Takeaways:

• A margin account gives you additional buying power to buy or short securities. This could amplify your profits or losses.
• You may trigger a margin call during margin trading.

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What is margin trading?

Margin trading means borrowing money or securities from your broker to trade, using the assets in your account as collateral. In other words, it allows you to leverage what you already own to purchase additional securities or short sell securities. Just like in a loan, you need to pay interest on the money or securities you borrow.

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What can you do with a margin account?

In a cash account, you can only use your own deposit to trade. In contrast, a margin account gives you additional buying power based on your account value, with which you can buy or short securities.

When an investor is bullish towards a security, he may use his additional buying power to buy more shares.

Suppose Jack believes Stock A will surge in two weeks, and he has $5,000 in his margin account. To increase his profits, he borrows another $5,000 from the broker and makes a total investment of $10,000 in Stock A (at $20 per share).

If Stock A surges to $25 as Jack expected, his returns could be $2,500. In this case, his returns are doubled compared with buying in a cash account. However, if the stock tumbles to $15, his losses are also doubled.

When an investor is bearish towards a security, he may short a security.

Unlike Jack, Jane decides to sell short 500 shares of Stock A (also at $20 per share).

If Jane is right and the stock drops to $15 a week later, she can close her short position by buying the shares back at $15. Her returns would be $2,500.

However, if Jane waits for a week, and the stock climbs up all the way to $25, she would have to buy back the shares at $25 per share to stop losses. Her losses would be $2,500.

*Note: Margin interest is not included in the calculation of profit/losses of the above two examples.

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