Margin Account

When an investor uses money borrowed from another party to help finance the purchase of securities, they are said to be using leverage. The use of leverage allows the investor to increase the total size of the transaction. As the value of the security changes over time, gains or losses are amplified.

To reduce the risk of default on the transaction, the brokerage firm will require the investor to open a margin account. As the value of the securities change each day, money is withdrawn or deposited into the account. The broker will also establish a minimum margin requirement based on the amount of exposure the investor has to the market. When the balance in the account falls below this threshold, the broker makes a maintenance call, or "margin call," requiring the investor to place additional funds into their account. The securities involved in the transaction can also be used by the broker as collateral for the loan.

Typically, brokers will lend investors 50% of funds required to purchase securities. In exchange for this service, the investor provides the broker with interest payments on the loan. Purchasing securities using leverage increases the overall risk of the investment. While greater returns are possible, so are the losses.

The current price of Company A's stock is $20.00 per share. Lindsey would like to purchase 500 shares of Company A's stock for $10,000. She opens a margin account with a brokerage firm, which requires initial margin of 50% and a minimum requirement of 30%. To complete this transaction, Lindsey would need to provide the broker with:

= 50% x $10,000, or $5,000 to purchase the stock; and = 30% x $10,000, or a minimum of $3,000 would be placed in her margin account

Lindsey decides to purchase the shares of Company A's stock, and she places $4,000 into her margin account. Over time, the price of Company A's stock has declined to $18.00 per share. At this point, Lindsey's loss on the stock would be calculated as:

= ($20.00 - $18.00) x 500 shares, or $1,000

As the stock's price declined, the broker removed the $1,000 loss in value from Lindsey's margin account, which now has a balance of $4,000 -$1,000, or $3,000. If the price of Company A's stock were to fall below $18.00, a margin call would be made to Lindsey, asking her to place additional funds into her account.