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The Good the Bad and the Ugly of Margin Accounts

The Good
The good is obvious: when you want to make a purchase the cash is available to do so.  There is no worry about the settlement period and you are free to trade as frequently as desired. 

The Bad
The bad is often overlooked. You are buying stock with money that you do not have or if shorting borrowing shares that you do not own. At some point you will have to pay the money/shares back with an interest payment. 

The Ugly
The ugly part is when you borrow money to buy a stock and that stock goes down or up if you borrowed shares to short.  Not only are you looking at a losing trading but it is on borrowed money/shares. You have to pay back the loan and you can not sell or cover the stock for what you paid for it.  That situation can get ugly fast. 

During the Internet bubble there were very loose requirements on margin borrowing.  Investors borrowed many times the value of their account. The Internet bust wiped out a lot of investors who were on margin. Fortunately we now have some very strict margin requirements to protect those who would otherwise use margin foolishly. 

Margin Requirements
The SEC and brokerage firms now require you to have a certain amount of equity in your account to balance the debt load from margin borrowing. The broker requirement is typically called a house requirement. The SEC requirement is typically called an exchange requirement. 

When you overextend your buying power you face a margin call. You can get yourself into this situation by borrowing money and having your positions decline on you thus giving you less equity. You have 5 days to settle the imbalance within your account. If you fail to do so your broker will likely take action to cover the balance by selling shares in your account to get you back into a favorable equity position.  In these cases the brokerage will sell your stocks and may not make the best selling decisions.  Instead they take the sell anything at any price approach selling however many shares required to cover your debt. 

When we short positions a margin account is needed because you are borrowing shares to sell short. You are borrowing something that you do not own and then selling it. The broker requires you to borrow from them on margin. 

When using margin you must be a very disciplined trader.  Having a margin account can make all the difference in the world when you want to swing trade or short stocks in a declining market. Without margin you are left on the sidelines during the settlement period. That is not the place you want to be if there is a sudden down draft in the markets or in a Bull market for that matter.  Margin is a great tool if you know how to use it and if you are an active trader.  You need a margin account to be effective.

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