In this tutorial, you will learn the mechanics of a margin account. You will learn how to set one up, what its limitations are and how to engage in margin transactions. You will also learn when to use a margin account and its potential rewards and risks.

This tutorial contains the following lessons:

• Why Use A Margin Account?
• How Do You Set-up a Margin Account?
• What Are The Limitations In Margin Accounts?
• What Is A Margin Call?
• How Do Margin Transactions Work?
• Is A Margin Account For You?

WHY USE A MARGIN ACCOUNT?

Let's begin with the terms.

Margin account. An account you establish at a brokerage firm that lets you borrow from your broker to buy securities or for any other purpose.

Margin. The amount you must deposit when you use your broker's credit to buy securities.

A margin account lets you borrow cash quickly at favorable rates. You make a secured loan against your own portfolio. The advantage is that you do not have to sell any of your portfolio to obtain the cash. Furthermore, you have no repayment schedule. You are free to repay the loan at anytime, unless your collateral falls below the required amount. While most investors use the borrowed cash to buy additional securities, you can use it for any purpose. Having a margin account is like having a pre-approved credit line with your broker. However, the wholly owned securities in your portfolio are collateral for the loan. You will also need a margin account if you engaging in short sales. See the tutorial on Selling Short for more information.

Interested? Let's see how to establish a margin account.

HOW DO YOU SET-UP A MARGIN ACCOUNT?

What Are The Types Of Brokerage Accounts?

You have a choice of two types of brokerage accounts. You can open a cash account or a margin account. A brokerage cash account is a simple account you may use to buy and sell securities. You pay for transactions with cash. A margin account is a credit account. You pay a certain percentage of the purchase price of your securities and borrow the remainder from the brokerage firm.

When opening a margin account you must sign a margin agreement form, which outlines the rules for using your margin account. Once you have placed securities in you margin account, the broker will price them and tell you the value of your portfolio and how much you can borrow. You can borrow on margin anytime thereafter, without having to complete any other applications or forms.

WHAT ARE THE LIMITATIONS IN MARGIN ACCOUNTS?

Federal Reserve regulations, as well as other Regulatory Bodies, apply restrictions on margin accounts. You may not borrow the full amount of your portfolio. The Federal Reserve Board (FRB) regulates the amount of credit brokers can extend to its customers. Currently, you can borrow up to 50% of the value of your marginable stocks. In the past, it has varied between 40 and 100 percent.

The "New York Stock Exchange minimum initial equity requirement" holds that your equity be at least $2,000 whenever you enter into a new margin account transaction.

The "NYSE Minimum Maintenance Rule" requires that the equity in your account must be at least 25% of the current market value of margined securities.

All of these requirements are minimums and can be increased at any time by your brokerage firm and/or by the Security Industry Regulator.

Not all securities are fully marginable. Your broker can tell you which ones would not apply. However, the list of non-marginable securities is small, but your brokerage firm may have its own requirements. Generally, money market funds, municipal bond funds and some bonds are not marginable as well as some stocks.

Your broker will charge interest on the margin loan as long as it is not repaid. The rates vary but generally will go down as the amount you borrow increases.

You cannot have shares registered in your name and sent out to you when you have purchased these shares on margin. They must remain in the margin account in "the street name." You will receive credit into your account for any dividends they pay. You may remove the shares from the margin account only after you have repaid the amount you borrowed on margin to purchase these shares.

If the value of your collateral rises, you can withdraw the amount over your minimum requirement or use it for additional investments.

WHAT IS A MARGIN CALL?

A margin call is a demand by your broker for you to deposit cash or fully marginable securities with your broker. Your broker makes a margin call for collateral when you first borrow money.

If the value of your collateral falls below the broker's minimum requirement (usually about 30% of the loan), you will receive a margin call by letter, telephone, telegram, or other means, to request additional collateral in the form of cash or fully marginable securities to meet the requirement. However, only a percentage of a security's market value can be used to meet your margin call. If you fail to meet the margin call, your broker is authorized (remember the margin agreement form) to sell the margined securities and any other collateral needed to repay the loan plus interest and commissions. You are responsible for any deficit that may remain after your assets are sold.

Let's see how a margin transaction works.

HOW DO MARGIN TRANSACTIONS WORK?

Margin accounts let you magnify your gains when you choose wisely. But, choose unwisely, they also magnify your losses. You benefit from using margin only if the stocks you purchase rise in price. If they stay the same, or worse, drop in price, you lose. You must pay interest on the margin whether your stock rises or not. Here is an example:

Suppose you have an opportunity to purchase an Internet stock. It is selling for $11 a share. You have about $ 5,500 to invest. So, you purchase 500 shares. A year later, you sell the stock at $33 per share. You receive about $16,300 after commissions on a $5,500 investment. Not bad. However, instead you could use margin. Suppose you bought on margin 1,000 shares of an Internet stock for $11 a share. You put up 50% of the stock's purchase price ($5,500) and borrowed the other 50% from the brokerage firm. Next year, the stock is valued at $33 per share. If you sell the stock and repay the broker, you are left with close to $27,000 after commissions and interest charges. That is even better for a $5,500 investment.

However, what if your stock had dropped in price to $8 dollars? In the cash transaction, you would receive about $4,000 back excluding commissions, from your original $5,000. In the margin transaction, you would receive $8,000, repay the $5,500 you borrowed from your broker, and you would be left with $2,500 of your original $5,500, excluding commissions and interest.

IS A MARGIN ACCOUNT FOR YOU?

Before you decide to rush out an open a margin account, let us review the main points.

• A margin account is essentially a collateralized line of credit.
• You may use proceeds from a margin account for other investments and other purposes.
• You will pay interest on money borrowed from a margin account.
• If you use the margin to buy securities, you must meet certain minimum margin requirements and maintain the appropriate amount of collateral. If the collateral level falls, you can expect a margin call.
• Using margin to buy securities can magnify your gains. It can magnify you losses as well.

This concludes this tutorial.