How Margin Accounts Work

Margin Account Basics

When you buy stock using a cash account, it's a relatively straightforward process: You give the broker money and the broker gives you shares of the stocks you want to purchase. You own the stocks outright and can control how the broker deals with them -- that is, you decide when and how much to sell. Your equity in the stocks is 100 percent. If the value of the stock rises, all of that profit is yours. If it falls, the opposite happens. For example, if you buy 100 shares of a stock worth $100 per share, you own $10,000 worth of stock. If the stock increases in value to $150 per share, you now own $15,000 worth of stock. If the stock falls to $75 per share, you now own $7,500 worth of stock. You don't owe anyone any money, other than broker commission fees.

Buying on margin means you're only paying cash for a portion of the total shares you purchase. The rest is purchased as a loan from the broker. The collateral from this loan is the stock you purchased with cash. Here's an example:

You only have $5,000. You open a margin account with your broker and purchase 100 shares of a stock that's worth $100 per share. You now own $10,000 in shares -- even though you only invested $5,000. The broker loaned you the other $5,000 by giving you those additional shares. The $5,000 in shares you paid for with your own cash is used as the collateral against the loan. This is the most important aspect of margin accounts to understand, because it works just like any other loan collateral -- if the broker thinks you can't repay what you borrowed, he or she can repossess those shares. Where margin stocks are concerned, this is a lot worse than the bank taking your car because you missed too many payments. Why? Because of the minimum margins and maintenance minimums you have to keep on the account. We'll explain those in the next section.