Question

Research margin accounts and write a 2-3 page paper (not including the cover page or a reference page) on:

• What is a margin account?

• Why would investors use one?

• What are the possible downsides to buying/selling securities on margin?

• A minimum of two properly cited references are required, with at least one being from an outside source you find by searching the Internet.

Answer 1

Margin account

A margin account is a brokerage account in which the broker essentially lends the customer cash to purchase securities. The loan in the account is collateralized by the securities purchased and cash, and comes with a periodic interest rate. Because the customer is investing with borrowed money, the customer is using leverage, and will magnify both losses and gains because of it.

A margin account lets an investor borrow money from a broker to purchase securities up to certain limits. For example, an investor with $2,500 in a margin account wants to buy Company A’s stock for $5 per share. The customer could use additional margin funds of $2,500 supplied by the broker to purchase $5,000 of Company A’s stock, or 1,000 shares. If the stock appreciates to $10 per share, the investor can sell his shares for $10,000. If he does so, after repaying the broker's $2,500, he will have profited $7,500, assuming no other costs. In reality, the investor will also have to pay interest on the margin lent to him by the broker, as well as other trading costs, so his profit will be less.

Why would investors use one?

Buying on margin is borrowing money from a broker to purchase stock. You can think of it as a loan from your brokerage. Margin trading allows you to buy more stock than you'd be able to normally. To trade on margin, you need a margin account. This is different from a regular cash account, in which you trade using the money in the account.

By law, your broker is required to obtain your signature to open a margin account. Once the account is opened and operational, you can borrow up to 50% of the purchase price of a stock. This portion of the purchase price that you deposit is known as the initial margin. It's essential to know that you don't have to margin all the way up to 50%. You can borrow less, say 10% or 25%. Be aware that some brokerages require you to deposit more than 50% of the purchase price.

You can keep your loan as long as you want, provided you fulfill your obligations. First, when you sell the stock in a margin account, the proceeds go to your broker against the repayment of the loan until it is fully paid. Second, there is also a restriction called the maintenance margin, which is the minimum account balance you must maintain before your broker will force you to deposit more funds or sell stock to pay down your loan. When this happens, it's known as a margin call.

Borrowing money isn't without its costs. Regrettably, marginable securities in the account are collateral. You'll also have to pay the interest on your loan. The interest charges are applied to your account unless you decide to make payments. Over time, your debt level increases as interest charges accrue against you. As debt increases, the interest charges increase, and so on.

Therefore, buying on margin is mainly used for short-term investments. The longer you hold an investment, the greater the return that is needed to break even. If you hold an investment on margin for a long period of time, the odds that you will make a profit are stacked against you.

Not all stocks qualify to be bought on margin. The Federal Reserve Board regulates which stocks are marginable. As a rule of thumb, brokers will not allow customers to purchase penny stocks, over-the-counter Bulletin Board (OTCBB) securities or initial public offerings (IPOs) on margin because of the day-to-day risks involved with these types of stocks. Individual brokerages can also decide not to margin certain stocks, so check with them to see what restrictions exist on your margin account.

Downsides on buying/selling securities on margin-

Buying on margin comes with risks.

If an investor purchases securities with margin funds, and those securities appreciate in value beyond the interest rate charged on the funds, the investor will earn a better total return than if he had only purchased securities with his own cash. This scenario is the advantage of using margin funds.

On the downside, the brokerage firm charges interest on the margin funds for as long as the loan is outstanding, increasing the investor’s cost of buying the securities. If the securities decline in value, the investor will be underwater on the margin funds, and will have to pay interest to the broker on top of that. In addition, if a margin account’s equity drops below the maintenance margin, the brokerage firm will make a margin call to the investor. Within a specified number of days, typically within three days, the investor must deposit more cash or sell some stock to offset all or a portion of the difference between the security’s price and the maintenance margin.

A brokerage firm has the right to increase the minimum amount required in a margin account, sell the investor’s securities without notice or sue the investor if he does not fulfill a margin call. Therefore, the investor has the potential to lose more money than the funds deposited in his account. For these reasons, a margin account is most suitable for a sophisticated investor with a thorough understanding of the additional investment risks and requirements.

Buying on margin can potentially pump up your profits, but using margin comes with some very steep risks. The biggest risk you have when buying on margin is that you don't know, with any certainty at least, that the stock you purchased or short-sold will do what you expect. Even the best stock pickers in the world are wrong around a third of the time, which means there's a lot of inherent risk in playing with margin.

For example, if the value of your investment(s) declines you may be required to deposit additional capital to cover your margin. In fact, it's possible to lose more money than your initial investment when buying on margin. Let's remember that margin is nothing more than a loan you've accepted from your broker. If your account equity isn't high enough to maintain your position, your broker will often allow a week to add additional funds to satisfy your margin call otherwise it will liquidate some, or all, of your position. Ultimately, the broker needs to protect its loan, which means it will have no qualms about liquidating your position if you're not in compliance.

Another oft-overlooked disadvantage of buying on margin is that you'll owe interest on your loan. Just like with any bank, the higher the amount of the loan, or the more you trade, the lower your interest rate will be. But, make no mistake about it; your margin rate will be substantially higher than the prime rate. Currently, most investors buying on margin will owe about 8% per year on the amount they borrow. If you don't believe you'll make at least 8% per year, then investing with margin may be a poor idea.

(Include cover page and reference page yourself. I hope the rest helps you with your paper)