You may have heard of margin accounts several times and wondered what they were and if you needed one. Basically, margin accounts give you greater flexibility for trading with your brokerage. However, the added benefits come with greater risks, so please read your broker’s agreements carefully.
Benefit #1 – Borrowing Money
There are three main benefits of having a margin account over a standard cash account. The first one is the ability to instantly borrow money from your brokerage in order to buy more shares than you could afford with just your cash. This is called leverage because it allows you to do more with less. Of course with the ability to gain much more, there is also the ability to lose that much more! Given that fact, it is generally not recommended to borrow very much money for trading. However, the borrowed money may also be used for a personal loan rather than trading. This is an easy way to get cash fast without a complicated loan application.
Brokerages usually offer very competitive interest rates because your cash and stocks are used as collateral. Interest will usually be charged for every day that the loan is outstanding, so you probably do not want to use margin for a long-term investment.
Benefit #2 – Day Trading
The second benefit is it makes day trading much easier by avoiding the settling period. With a normal cash account you must wait three trading days after you sell your shares in order to use the money from the sale. With a margin account, the brokerage effectively lends you that money during the settling period so you can continue trading right away.
However, you cannot do unlimited day trading without meeting some more requirements. If you perform more than three trades within a five-day trading window, the government will consider you to be a “pattern day trader”. That really just means that you will be required to keep at least $25,000 in your margin account at all times to continue day trading. So be mindful of how many day trades you perform. Many beginners get caught in this trap without realizing it.
Benefit #3 – Short Selling
The third benefit is the ability to short-sell. Short selling allows you to make a profit by selling high and then buying low on a company that is falling in price. The short sale involves you borrowing shares from your brokerage and immediately selling them on the open market. You will then owe the brokerage that many shares in the future. When you finally do buy back the shares and return them to the brokerage, hopefully you will have made a profit. Keep in mind that short selling involves extra risks and restrictions by your brokerage and the government bodies.
Maintaining Margin Requirements
If you borrow money within your margin account, your current cash level and stocks are used as collateral. Therefore, if your account drops in value, so does your collateral. If that value drops too far, your brokerage may request that you send them more cash. This is called a “margin call”. If you fail to meet their requirements, they have the right to automatically sell some of your shares in order to get back some of the cash you borrowed from them.