What it is:
How it works (Example):
Let's assume you have $2,500 and Company XYZ trades at $5 a share. In a regular brokerage account, you would only be able to purchase 500 shares. If XYZ were to appreciate by $10, you would make $5,000 and earn a respectable +200% gain.
But with a margin account, you could borrow money from the brokerage firm and collateralize the loan with the Company XYZ shares. Margin requirements for equities are normally 2 to 1 for the average investor, meaning you purchase double what your cash balance is.
With the $2,500 from the previous example, an investor with a margin account would be able to purchase $5,000 of Company XYZ or 1,000 shares. That same $10 price move would mean you now make $10,000 and earn a +300% return.
But margin is a double-edged sword, and losses are also magnified. Additionally, if the investor's equity in the account drops past a certain point, say 25% of the total purchase amount (called the maintenance margin), the brokerage firm may make a margin call , meaning that within a few days you must deposit more cash or sell some of the shares to offset all or part of the difference between the actual stock price and the maintenance margin.
Why it Matters:
Margin accounts allow investors to make investments with their brokers' money. They act as leverage and can thus magnify and gains. But they can also magnify losses, and in some cases, a brokerage firm can sell an investor's securities without notification or even sue if the investor does not fulfill a margin call . For these reasons, margin accounts are generally for more sophisticated investors who understand and can handle the additional risks involved.
It is important to read the margin agreement when setting up a margin account in order to understand the conditions of your account and the risks associated with it.