As a beginner learning how to make money in the stock market, you might have heard the term margin accounts or a margin call. With that said, what is a margin account? And how is it relevant to your options trading journey?
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How does a margin account work?
Margin accounts are brokerage accounts in which the broker lends you money to buy stocks. The initial amount borrowed is limited to 50% of the purchase price of a stock.
Based on this loan, you have to pay interest. The stocks that you buy are then used as collateral in case the stocks depreciate below a certain value.
For many investors, margin accounts present an advantage as it increases your buying power. In the case where you might not have enough capital to make a trade, you can borrow money when using a margin account!
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Are margin accounts a good idea?
Margin funds usually provide an advantage over investing with just cash. For those that don’t know the difference between a margin account vs cash account, a margin account allows you to have more buying power compared to just using a cash account.
This is because you can invest more than what you have without a bank loan.
Additionally, if the stocks you bought increase in value above the interest rates charged for the margin funds, youll make a profit!
Risks involved with margin accounts
But what about the potential risks with this strategy?
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There are significant risks involved with trading on margin.
Margin is a double-edged sword.
You can make more money, but you can also lose more money.
Especially when trading options, since the buying power reduction for stocks is about 50% of the market value of the equities, and when trading options the buying power reduction is ~10% - ~20%.
During recessions, or black swan events, it’s possible for option sellers to be forced into a margin call and sustain large losses if they trade too large.
How long can you use margin money?
When trading stock, you can keep your loan for as long as you need, provided that you meet the brokerage firms margin requirements. Keep in mind that you also have to pay the interest on your loan.
Option sellers DO NOT pay margin interest, but equity traders do.
When trading equity, the interest charges you owe the brokerage firm increase the longer you borrow funds from the brokerage firm.
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What is a margin call?
As a trader, you’ll receive a margin call when the value of the securities you bought drop below a certain amount, the brokerage firm you borrowed from can either ask you to sell your stocks or it will request that you add more money into your margin account to cover the brokerage’s risk.For those who are new to margin accounts, this may seem like a bad deal for you to agree to, as the brokerage firms have way more control over the money in the account than you do!
In the United States, the Federal Reserve Board has set a maintenance margin for margin accounts. This means that investors like you need to make sure the overall amount of money (not including what you initially borrowed) in the account stays above a certain number!
When it comes to different firms, this can get even more complicated as their margin accounts can demand a higher margin maintenance (at the brokerage firms’ discretion).
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In the United States, most option traders use Regulation T or Portfolio Margin.
Brokerages usually offer Portfolio Margin to accounts over ~$150,000.
Portfolio margin looks at the risk of your entire portfolio, in aggregate.
In general, Portfolio Margin can offer about 3x - 5x as much buying power to options traders when compared to Regulation T.
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When dealing with margin accounts, it can be a great way for options traders to increase their buying power by up to 3x -5x times, when compared with buying stocks.
However, this strategy also introduces a lot of risk.
Overall, trading options on margin, when implemented correctly, can generate a large profit.
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