Buying on margin: What is a margin account?

What is a margin account?

A margin account is an investment account where the account holder has the option of borrowing funds from the broker to purchase securities and other investments. Buying on margin involves a combination of money borrowed from the broker and a minimum margin or minimum required deposit (cash) from the client.

The amount the account holder can borrow depends on the type of investment they want to make, the share price of the security, and the amount they can contribute from funds in their margin account. A margin account holder's existing portfolio of investment assets can serve as the collateral or guarantee for the borrowed money.

Cash account vs. margin account. What's the difference?

Investors who want to open a non-registered account can select between a cash account or a margin account. Both accounts share many similarities but the ability to leverage one’s investments in a margin account provides additional options to the investor.

Why use a margin account?

A margin investment account provides self-directed investors with a number of benefits. These include:

• Leverage effects: The power of leveraging lets investors increase their exposure by borrowing funds and amplifying the value of their returns.
• Flexibility: Margin accounts provide financing that allows for a level of maneuverability that is not available in a cash account by:
  • providing quick access to funds at all times
  • offering access to market opportunities
  • making emergency funds available for unexpected expenses
  • allowing account holders to use funds for RRSP contributions, car loans, etc.
• Advantageous interest rates: Borrowing using a margin account is cost-effective, offering a lower interest rate than most personal loans or credit cards.

Additionally, a margin account is required when short selling securities or using certain option trading strategies such as cash secured puts.

How risky is a margin account?

Investing with a margin account can be riskier than investing in a cash account, but it is important to remember that it is how an investor chooses to use the account that will impact the potential risk level. To put this into perspective, a high-performance car can go very fast, but that doesn't mean that the driver is obligated to drive fast. Similarly, with a margin account, there is no obligation to borrow on margin or borrow up to the maximum amount. 

It is essential to remember that, with a margin account, it's easier to lose more than your initial investment. If you are in a margin call because the value of your investments decreased, and if you cannot cover the amount by adding funds, the brokerage firm can sell your securities to cover the margin call.

How does a margin account work?

One of the key benefits of a margin account is the ability to borrow funds at favorable interest rates to increase the value of an investment buy order. A margin loan is a type of loan where the money you are borrowing is secured against the investments that you are buying with the funds or already hold in your margin account.

 If an investor decided to use borrowed money, they will be charged interest at the margin rate. There is no fixed repayment schedule for the borrowed amount. If no payments are made, the interest charged will be added to the amount borrowed, as long as the available margin remains positive this won’t be a problem.

The investor could be subject to a margin call if their assets value decreases. The broker providing the margin will issue the investor with a request to cover the margin call if the value of the investment descends below the maintenance margin (available margin). The broker may also hold a certain amount of margin as a security cushion in the margin account to cover for any decrease in the value of the investment.

What is leverage?

Leveraging is the principle of using a smaller amount of money to borrow a more significant sum that an investor then uses to magnify their investment in a stock, bond or other type of security. Like a lever in a tool kit, it gives the investor additional financial power that they can apply to their investment purchase.

What is buying power?

Buying power is the amount available through your margin account to purchase securities. Buying power is calculated by subtracting the value of the security cushion from the available margin, which is the cash in the account and the value of the margin provided by the broker.

Available Margin = (Cash + Loan Value)

Buying Power = (Cash + Loan Value) - Security Cushion

At NBDB, the security cushion is calculated at 30% of the value of the biggest loan value on a security held in an investor's margin investment account.

What is loan value?

Different asset types are subject to different margin loan amounts. The loan value percentages shown in the chart below are the legal maximums authorized by the Canadian Investment Regulatory Organization (CIRO). If it chooses, a brokerage firm can lower the percentage of a margin loan it is willing to provide an investor.

Examples of a margin transaction

Here are two examples of a margin transaction. One is based on increasing and the other on decreasing asset value.

An Investor would like to purchase 1000 shares of ABC stock at $10.  A total trade value of $10,000.

The marginable rate of that stock is 70% since its value is over $5 per share.

Therefore, the value of the loan would be $7000. 70% of the total trade value.

The minimum required deposit from the investor would be $3000. 30% of the total trade value.

Scenario A – Profit

• The stock price increases from $10 to $12
• If the investor sells the stock, they make $12,000 - $10,000 = $2000.
• The investor initially invested $3000 of their own money to purchase 1000 ABC shares at $10/share on margin
• Based on the initial investment of $3000, the $2000 represents a profit of 67%

Scenario B – Loss

• The stock price drops from $10 to $8
• The value of the total investment has decreased from $10,000 to $8000. A loss of $2000
• If the investor sells all 1000 shares, available funds are $8,000
• Subtract the value of the $7000 initial loan from the outstanding amount of $8000
• The investor is left with $1000 of their initial $3000 investment. A loss of 67%

What is a margin call?

Brokerage firms will set a limit called a maintenance margin, which is the minimum amount an investor must have available in the account.

A margin call occurs when the available margin becomes negative because the investment decreased in value. In this case, the investor must deposit more funds into the account or sell securities. If the investor does not take action, the broker will intervene and sell some of the investor’s securities to pay down part (or all) of the loan.

How to calculate a margin call and keep an investment position?

As mentioned above, a margin call happens when the value of the leveraged asset goes down. But how is the margin call calculated, and how does the investor hold the position or cover for the loss?

If the investor in Scenario B above wanted to hold the investment position following the margin call, they would have to cover for the loss, as follows:

• The value of the investment is now $8000, a 20% decrease from the original investment of $10,000
• Based on the 70% marginable value ($8000 x 70%), $5600 is now the maximum size of the loan from the broker
• The investor initially borrowed $7000
• The difference between $7000 – $5600 = $1400
• The margin call is $1400. This amount is the minimum the investor would need to deposit in cash.

How to avoid a margin call?

A decrease in the value of an investment is always a possibility. Independent investors should always be aware of the risks and employ strategies to mitigate losses from a margin call and protect their assets. Some of the ways to avoid a margin call include:

• Always monitor investments.
• Do not use up all of the available margin.
• Use a cushion on the loan value for 'what if' scenarios.

Use stop loss orders to protect gains and minimize losses on holdings in a margin account in case of a market downturn.

How to settle a margin call?

The way to settle a margin call is to do one of the following:

• Deposit additional cash into the margin account.
• Transfer additional securities into the margin account.
• Sell securities to cover the value of the margin call.

How to open a margin account?

It is possible to open an account online with NBDB. Every brokerage firm has its own internal credit and risk policies when it comes to authorizing the opening of a margin account, send us a secured message or call us for more information.

Investors considering margin accounts need to have a higher tolerance for risk, a good knowledge of the markets, and be comfortable enough to weather financial storms when they occur. They must also monitor closely their investments on margin. Buying on margin has its risks, but it remains an effective and powerful way to help independent investors make their money grow.