In a world of investing, margins can help you achieve your goals faster. However, there are advantages and disadvantages to owning a margin account. How do you know if this is right for you.
What Is A Margin & How Does It Work?
A margin account is an account that you set up with your broker. It’s money you borrow against to purchase securities (Stocks, bonds or mutual funds)in your brokerage account.
Mary and Ted are close siblings. They enjoyed discussing the stock market together. Ted told Mary to sign up for a margin account. She didn’t know how a margin worked but, she trusted the advice of her brother and decided to do it. She was immediately approved when she called her broker because her account was a little over $10,000. She thought to herself, this is something she might never have to use. One day she was looking at the stock market and she kept hearing about this high flying stock that everyone needed to buy. She questioned it at first, then she decided to take the leap. She purchased 100 shares at $80 /share. This meant that Mary now had a margin debt of $8000. Since Mary had securities in her account to cover her purchase, the broker allowed her to put the new purchase on margin.
Advantages to owning a margin account
- You borrow against your securities. As long as your securities do not decrease in value your margin account will maintain a good standing.
- It increases your buying power so you can attain wealth faster.
- You can purchase more shares because you are not using your money.
The stock that Mary purchased did very well at the beginning. She stopped looking at the stock market. One day Mary received a phone call from her broker asking her to put up $3000. She wondered to herself, “why”? They wanted the money by 12:O’Clock the next day. She turned on the television to the stock channel, everything was in the red. Even her regular stocks had plummeted. She didn’t have the money to pay so she could not send her broker the $3000 they were requesting. They sold out Mary’s whole account. She now owned nothing. What will she do and how will she tell Ted?
Disadvantages to owning a margin account
- Extremely risky. You should always know your risk before you get into something you don’t know.
- You will not sleep at night. The stock market is a volatile investment and you can lose everything.
- The interests that you can incur with margin debt can put you into an even deeper hole.
- You can get margin calls. When the broker called Mary to ask her for $3000, that was a margin call. Since her account value dropped, the broker wanted her to add money to her margin account. Some brokers will sell 3x what they are asking. Remember the market goes up and down so be careful.
If you have or you are planning to invest on margin know the risk. Diversify your assets. Save in an emergency fund to protect yourself just in case.