You can choose from dozens of online brokerages when you want to start trading stocks. Many of these offer discount commissions. Almost all brokers will provide you with the opportunity of opening a margin account. If you want to trade stocks without margin, politely decline.
Margin refers to money a broker lends you to purchase securities. To qualify for a margin account, you must fill out an application and disclose financial information. Brokers charge interest on margin loans, which, under the Federal Reserve Board’s Regulation T, can cover up to 50 percent of a security’s purchase price. Higher percentages are available in portfolio margin accounts, which consider hedged positions. If you purchase stock on margin and the stock price drops, your broker may call you with a request for additional collateral. If you don’t quickly comply, your broker will sell your stock, thereby locking in your loss.
Margin is Leverage
Margin is a form of leverage, which is the use of debt to increase the size of an investment. For example, if you have 50 percent leverage, you can buy 200 shares while putting up only enough cash for 100 shares. If the price climbs 5 percent, your 200 shares receive the same benefit as a 10 percent rise for 100 shares. You are levered two-to-one. Your hesitancy to use margin might stem from the dark side of margin, which is increased risk. A 5 percent drop on your margined shares hands you a 10 percent loss and probably a margin call.
If you are averse to leverage-related risks such as margin trading, you’ll also want to avoid certain other investments. Some exchange-traded funds use leverage to double or triple returns -- and risks. Options are leveraged in that they allow you to control a relatively large amount of underlying stock for a small down payment. Depending on how you play options, you can lose more than your initial investment. You also might want to avoid shorting stock, because it requires you to borrow shares that you then sell.
Your broker will allow you to trade from two accounts -- one margined, the other not -- if you wish to limit but not completely eliminate the use of margin. You can also arrange a lower margin limit on your account if you want a mild amount of leverage. Margin interest you incur for the purchase of taxable securities is tax-deductible. You deduct margin interest in the year your broker collects it. Individual retirement accounts do not allow you to borrow money from your account or to pledge it as security for a loan. For this reason, IRA accounts can’t take margin loans or borrow securities for shorting.
Video of the Day
- U.S. Securities and Exchange Commission: Margin: Borrowing Money to Pay for Stocks
- U.S. Securities and Exchange Commission: Leveraged and Inverse ETFs: Specialized Products with Extra Risks for Buy-and-Hold Investors
- The Options Guide: Long Call
- U.S. Securities and Exchange Commission: Short Sales
- IRS: Publication 550 Investment Income and Expenses
- IRS: Publication 590 Individual Retirement Arrangements
- Thinkstock Images/Comstock/Getty Images