Margin Account

A margin account is a type of brokerage account in which the investor can borrow from the brokerage firm to buy securities. The Securities and Exchange Commission's description states both halves at once, which is the right way to hold it. A margin account is "a type of brokerage account in which the broker-dealer lends the investor cash, using the account as collateral, to purchase securities," and "margin increases investors' purchasing power, but also exposes investors to the potential for larger losses."

The word "margin" is used for two related things and both meanings appear in ordinary conversation. It names the account type, and it names the investor's own equity in the position, the part not funded by the loan. Buying on margin means using the loan; a margin requirement is a rule about how much equity must be present. This page covers the account and the borrowing mechanism together, because a reader who has one has the other.

One term of art that travels badly. Futures trading also uses the word margin, and it means something different there: a performance bond posted to the exchange rather than money borrowed from a broker. Nothing on this page describes futures margin, and treating the two as the same concept is a common and expensive confusion.

Why a loan magnifies losses more than it magnifies gains, in the only sense that matters. In percentage terms leverage is symmetric, and doubling exposure doubles the percentage move in either direction. The asymmetry is in survival. The loan is a fixed claim that does not fall with the market, so as the position loses value the whole loss lands on the investor's equity, and when that equity runs low the position can be closed by someone else at the worst available moment. A holder with no loan can simply wait. A borrower may not be permitted to.

The forced-sale power is the fact most borrowers underestimate, and the SEC states it in unusually direct language. If the value of the securities falls, the firm "can require you to deposit cash or securities to your account immediately, or sell any of the securities in your account to cover any shortfall, without informing you in advance." Then two qualifications that remove the escape routes people assume exist: "the brokerage firm decides which of your securities to sell," and "even if the brokerage firm notifies you that you have a certain number of days to cover the shortfall, it still may sell your securities before then." So the borrower does not control the timing, the amount, or which holdings are liquidated, and a stated deadline is not a commitment. The mechanics of the demand itself belong with the term for a margin call.

The regulated minimum is a floor, and the number that governs a real account is usually higher. The Federal Reserve's Regulation T sets the initial requirement for a margin equity security at "50 percent of the current market value of the security or the percentage set by the regulatory authority where the trade occurs, whichever is greater," at 12 CFR 220.12(a). The trailing clause is the operative part and is easy to read past, because it is what makes the federal figure a minimum that a self-regulatory organization can raise. A separate maintenance requirement then applies for as long as the position is held, set by the investor's self-regulatory organization rather than by the Federal Reserve, and it is that ongoing requirement rather than the initial one that determines when a shortfall arises. On top of both, firms impose their own house requirements: the SEC has noted that broker-dealers "may always collect additional margin from customers than required" under the applicable rules, and its own investor education adds that a firm "may at any time change the threshold at which customers are subject to a margin call." The practical instruction that follows is to read the margin agreement and ask the firm for its current house requirement, because that is the number that will be applied.

The loan has a running cost, and it is charged whether or not the position works. Interest accrues on the borrowed balance for as long as it is outstanding, which means a margined position must earn more than the borrowing rate before it earns anything at all. Rates on these loans move with prevailing short-term rates and vary by firm and by balance, so the cost of a strategy financed this way is not fixed at the moment it is entered.

Borrowing changes how the securities are held, which changes what protection applies. Fully paid securities and margin securities beyond what the firm may use as collateral are treated differently from securities pledged against a loan, and our page on brokerage accounts sets out the custody rules and what SIPC does and does not do. The short version for this page is that protection is strongest in an account with no margin borrowing, and that borrowing is a change in the legal position of the holdings as well as in the arithmetic.

What a margin account is used for beyond buying more stock. It is a requirement rather than a convenience for several activities, including selling short and, under the day-trading rules, for trades that are opened and closed on the same day. Some investors also use the borrowing capacity as a short-term source of cash without selling holdings, which avoids realizing a taxable gain but replaces one exposure with two: the market risk of the holdings and the obligation of the loan.

You sign a margin agreement, the firm lends against the value of the account, and interest accrues on what you borrow. The firm monitors the account's equity against its maintenance requirement. If equity falls below it, the firm can demand a deposit or sell securities.

A hypothetical illustration of the magnification. Priya has $10,000 in cash and borrows $10,000 from her firm to buy $20,000 of stock. Her equity is $10,000 and the loan is $10,000.

If the stock falls 25%, the holding is worth $15,000. The loan is still $10,000, so her equity is $5,000. She has lost 50% of her money on a 25% fall. Without the loan, $10,000 of stock falling 25% would have left her with $7,500, a loss of $2,500.

If the stock rises 25% instead, the holding is worth $25,000, the loan is still $10,000, and her equity is $15,000, a gain of 50% before interest. That is the symmetry people expect and it is real. What is not symmetric is what happens next in the losing case: at $5,000 of equity on a $15,000 position she may be below her firm's maintenance requirement, in which case securities can be sold to reduce the loan and the position is no longer hers to hold while it recovers. Interest on the $10,000 accrues throughout in both scenarios and is ignored here. All figures are illustrative.

Pros

• It allows a larger position than the cash on hand supports, and the percentage gain on the investor's own money is correspondingly larger when the position works.
• It provides access to cash without selling holdings, which can avoid realizing a taxable gain.
• It is a prerequisite for certain activities, including selling short.
• The borrowing is collateralized and administered by the firm, so there is no separate application or credit process for each use.

Cons

• Losses land entirely on the investor's equity, so a moderate fall in the securities can be a severe fall in what the investor owns.
• The firm can sell securities to cover a shortfall without advance notice, chooses which ones, and is not bound by a deadline it has stated.
• The requirement that binds is the firm's own, and the SEC notes a firm may change that threshold at any time.
• Interest accrues regardless of outcome, so the position has to clear the borrowing cost before it earns anything.
• Borrowing changes the custody treatment of the pledged securities, which matters if the firm itself fails.
• The forced sale arrives when prices are low by construction, which is the moment an unleveraged holder would be doing nothing.