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Cash vs. Margin. If you invest in stocks just with the money you have in your brokerage account, you are using a cash account. If you borrow money from the brokerage to invest in stocks, you are using a margin account. If you borrow money in a margin account to buy stocks, keep in mind that this is not at all "free" money. Your collateral for borrowing the money is the marginable securities in your account, which means they are forfeit if you cannot otherwise repay the margin loan. You also have to pay a fixed amount of interest on the borrowed money on a monthly basis, which can reduce your overall returns. Because IRAs and other retirement accounts are cash accounts, you cannot use margin in them.
Why Use Margin? Many investors use margin to "juice" up their returns, but fail to appreciate that it can also "squeeze" down their returns. Just as you can make more money than you otherwise would have by using margin, using margin inherently puts you in the Double Jeopardy round - where your running tally can either move up or move down much more quickly than without margin. The worst-case scenario is when a stock price drops so much that it causes a "margin call," which means you either add more money to the account or you automatically get sold out of the position at a loss.
What Stocks Are Marginable? The Federal Reserve Board currently regulates which stocks are marginable. As a general rule, stocks selling below $5 are never marginable and recent initial public offerings are rarely marginable, although it does happen on occasion. Beyond this, individual brokerages also can decide not to margin certain securities for various reasons. Because of this, your brokerage is always the best source of information for finding out whether or not a security is marginable.
Initial and Maintenance Margin Requirements. The amount you can borrow on margin is limited by both the Federal Reserve Board and the individual brokerage you use. There are two requirements - how much margin you can initially use and then how much margin you can have after you make the initial transaction. Although each brokerage is different, as a general rule 50% of the purchase price of any security can be margin. After you take the position, there is a maintenance margin account requirement that is normally much lower, often around 25%. Check with your brokerage to find out your initial and maintenance margin requirements.
Calculating Buying Power. After you find out the margin requirements at your brokerage, you can calculate your buying power. This is how much total stock you can buy given your current cash and marginable securities, including margin. For instance, if you have $3000 in cash or marginable securities and the initial margin requirement is 50%, you have $6000 in initial buying power ($3000 equity/($3000 equity + $3000 margin) = $3000/$6000 = 50%). Be very careful when calculating how much buying power you have in your account, as nonmarginable securities do not contribute at all to your buying power.
Margin Call. Should you fall below the margin requirements, you may be subject to a margin call. If so, you have three days to send in more cash or securities to cover the deficiency or you will be forced to sell out of your positions. How can you calculate how close you are to the requirement? If you took the $6000 position described above using $3000 in margin and your maintenance margin requirement was 25%, the position could fall as low as a total value of $4000 before you risked a margin call. ($1000 equity/($1000 equity + $3000 margin) = $1000/$4000 = 25%).
Personally I do not believe that the average investor should or needs to be using margin. Although very aggressive, experienced investors could probably margin their accounts up to 20% without incurring a margin call, the fact that your losses are exacerbated should give even the most fearless investor pause. However, because most brokerages will let you short stocks only if you have a margin account - even if you have the cash to cover the short in your account - you may, nonetheless, end up signing that margin agreement and sending it off to the brokerage.
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