Trading stocks on margin is a strategy that can increase the return on your investment because you don’t put up the full purchase price of the shares. Along with the increased profit potential, margin trading carries more risk. Before you decide to open a stock margin account and jump in feet first, be sure you understand the rules and the risks.
A stock margin account is a brokerage account that allows you to borrow money to make trades. You need a margin account to buy shares on margin, to sell stock short and to make some options trades. In general, you need a margin account for any transaction that might result in a loss greater than the amount of money you put up. Stock margin accounts are regulated by a combination of government agencies, stock exchange rules and the policies of individual brokerage firms.
Before you can buy on margin, the Financial Industry Regulatory Authority rules say you must have a minimum balance of $2,000 or 100 percent of the value of a transaction, whichever is less. Your broker can set a higher minimum. When you open a stock margin account, you are asking for credit, so your credit history will be checked. You must sign an account agreement making all securities and cash in your account collateral for any money you borrow.
The Federal Reserve Board requires at least 50-percent margin, meaning you have to put up that much or more to make a margin trade. Your broker may want a higher percentage. Suppose you decide to buy shares worth $5,000. If the margin requirement is 50 percent, you have to put up $2,500; however, if your broker wants 60 percent, the required margin goes up to $3,000. You can only use available margin equity to make a margin trade. Margin equity is the balance in your account minus any borrowed funds and the value of any in-the-money covered calls you have sold. This last rule is because in-the-money covered call options can be exercised by the buyer at any time, so the money may be withdrawn from your account without notice.
Suppose you buy stock on margin and the share price falls. You still owe what you borrowed. All of the loss comes out of your margin equity. For example, if you buy $5,000 worth of stock with a 50 percent margin and the price falls so the stock is worth only $3,000, your margin equity falls to $500. Typically, stock markets like the New York Stock Exchange require a 25-percent “minimum maintenance margin.” In this example, your margin equity is down to 17 percent. That’s less than the 25-percent minimum. Your broker can sell the shares to recover his money and you take a big loss on the trade. Brokers usually notify you with a "margin call," so you have a chance to deposit more money in your account. However, brokers are not required to issue margin calls. For this reason it’s a good idea to keep close track of open margin trades.