Definition§
A margin account is a brokerage account in which a broker lends money to the investor to buy securities. The loans in the account are collateralized by the securities and cash. Due to the borrowing involved, the investor is obliged to pay interest on the loaned amount. This leverage can potentially amplify profit but equally can result in larger losses.
Margin accounts are governed by several regulations:
- Regulation T of the Federal Reserve Board: Establishes initial margin requirements.
- Regulations from the National Association of Securities Dealers (NASD): Provides guidelines and restrictions for margin use.
- New York Stock Exchange (NYSE) Rules: Stipulate obligations and margin levels.
- Individual brokerage house rules: May impose more stringent standards.
Examples§
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Buying on Margin: An investor buys $10,000 worth of stocks by paying $5,000 in cash and borrowing $5,000 from the broker. The investor uses the purchased stocks as collateral.
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Leveraged Investment: An investor wants to invest in an IPO (Initial Public Offering). With a margin account, they can participate with a smaller initial cash outlay by borrowing the additional funds from their broker.
Frequently Asked Questions (FAQs)§
What is a margin call?§
A margin call occurs when the value of the investor’s margin account falls below the broker’s required minimum, prompting the broker to demand the investor to deposit more funds or sell off assets to meet the margin requirement.
How does interest on margin loans work?§
Interest on margin loans is typically calculated daily based on the loan amount and the broker’s margin rate. The interest is added to the investor’s balance and must be repaid along with the loan principal.
What are the risks associated with margin accounts?§
Risks include magnified losses due to leverage, margin calls when account value drops, and rising interest costs which can erode investment gains.
Who qualifies for a margin account?§
Eligibility criteria vary by broker, but generally, investors must meet minimum balance requirements, have a certain level of experience in securities trading, and pass a creditworthiness assessment.
Related Terms§
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Regulation T: A set of rules imposed by the Federal Reserve Board governing the amount of credit that brokers and dealers can extend to customers for the purchase of securities.
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Leverage: The use of various financial instruments or borrowed capital to increase the potential return of an investment.
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Margin Call: A broker’s demand for an investor to deposit more money or securities into the account when its value falls below a certain level.
Online References§
Suggested Books for Further Studies§
- “Margin: The Risk and Rewards of Trading on Margin” by Seth J. Letterman
- “The Neatest Little Guide to Stock Market Investing” by Jason Kelly
- “A Random Walk Down Wall Street” by Burton G. Malkiel
Fundamentals of Margin Account: Finance Basics Quiz§
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