The continuous growth of the brokerage industry has changed the way many investors do business in recent years. For many, there is no longer a need to call on a financial advisor, because all the information and tools necessary for good portfolio management are now available online. Among these tools is the margin account. But what are margin accounts and what do brokers do when it comes to using this trading tool to help you make a profit when trading stocks?
What are Margin Accounts?
This type of account offered by all brokers, allows investors to borrow money from the broker. The way it works is simple. You hold securities in an account, such as stocks or bonds. The broker is then willing to give you a cash advance equal to a certain percentage of the value of those assets, which allows you to buy more securities. The maximum loan varies depending on the type of product and its market value.
A 50% security deposit allows you to buy up to twice as much stock as you could buy using only the money in your account. So it is clear that you can make a lot more money in a margin account than in a simple cash account.
What is Brokerage Cash?
The brokerage cash is the amount that the broker is willing to make on margin accounts and depends on the securities that are held. The maximum brokerage cash may reach up to 95% if the securities held are government bonds. It may vary from 50% to 70% in the case of equities, depending on its quality and volatility. The stock price must be at least $ 2. For example, you buy 1,000 shares of XY Company at $ 10, for a disbursement of $ 10,000. Suppose the security is 50% marginal. So the broker is willing to lend you $ 5,000, and you only have to shell out $ 5,000. The impact on yield could be significant. If the stock appreciates to $ 12, you will make a profit of $ 2,000 on an investment of $ 5,000, or 40%, instead of 20% ($ 2,000 on $ 10,000).
What is a Margin Call?
If the stock price drops, you’ll face a margin call and need to provide new capital, so you don’t exceed your borrowing capacity on the stock. To prevent the investor from falling into margin calls at the slightest drop in the market, the broker generally requires a safety cushion. In the above example, it would be wise to cover $ 6000 and only borrow $ 4000. If the stock drops to $ 8, you won’t face a margin call because the loan will not exceed 50% of the value of the investment. If the decline was greater, however, you should respond to the margin call by depositing money into the account or selling securities.
Benefits of a Margin Account
Among the advantages of the margin account, there is the leverage effect, which allows you to have greater exposure to the market and therefore, to maximize returns. It also gives a lot of flexibility to the investor. First, the funds are available at all times, which allows you to quickly take advantage of good opportunities. Also, the available margin can be used as an emergency fund for unforeseen expenses.
The margin account is intended for investors who have a good tolerance for risk, a good knowledge of the markets, and who are financially comfortable. Leverage, when used well, allows you to gain more exposure in the market and optimize portfolio returns. Besides that, the eligibility criteria are generally minimal.