What is Margin Account

What Is a Margin Account? 

To understand what a margin account is, you must first learn the definition of margin. In the world of finance, margin refers to the money borrowed from a broker that is used to take a position in various investments. This allows a trader to take a much bigger position than usual and therefore can increase profit. However, a bigger position can also cause bigger losses if not used properly. 

A margin brokerage account lets investors deposit cash or other assets to be used as collateral. Any securities held by the broker can then be used for borrowing money and adding to a margin balance based on the total collateral deposited. Acting as the lender, the brokerage then charges an interest rate on the amount of money borrowed. 

Margin Interest Rates 

Margin interest is part of borrowing money from your broker. The loan comes with interest, and in this case, it is calculated on an annual interest rate for the life of the loan. Interest rates can vary from broker to broker, and generally do not add up too much if you are looking at short-term trades. However, longer-term traders do tend to have more to worry about, as the interest rates pile up over time. 

Typically, concerns about the interest you pay on a margin loan are something that people worry about over the time span of months, not minutes, hours, or even days. However, it is imperative that you understand there is a certain amount of interest that you will have to pay. 

Margin Call 

A margin call is when the value of your investments has fallen below the necessary collateral for the margin loan you have taken from the broker. 

If you receive a margin call, you have the choice of either depositing more money in your account or selling investments to maintain the account value that acts as collateral for the loan you have taken out. If you see the value of your investments fall quickly or simply enough, your brokerage can sell them without notifying you. This is what is known as liquidation. 

I margin call can force you to sell securities for less than the value initially paid, which is one of the most dangerous things about a margin account. However, if you use the proper risk management strategies, you should never find yourself anywhere near receiving a margin call or a forced liquidation. 

How a Margin Account Works

The most common reason for an investor or trader taking advantage of a margin account over a standard cash account is to utilize leverage. Leverage allows a trader to place bigger positions than a typical account will. 

The advantages of using leverage are pretty straightforward. If an investor or trader makes a buy order and the underlying contract or asset rises in value, a larger return is possible beyond what a regular spot or cash position would have provided. This is by far the biggest reason to use margin, to increase speculative gains. 

However, leveraged positions can result in losses at a faster rate than when trading on a cash account or spot trading platform, so caution is advised. Paying close attention to your risk is the most important thing a trader can do and is especially paramount in these accounts.  

Brokers will also charge a fee on positions and an interest rate on positions held using leverage, making overall money management a critical factor to overall success. However, the interest rates on the loans only constitute a small risk, as long as the trade isn’t held for an extended period of time. As it is calculated on an annual basis, it typically will be a very small charge per day. 

If a margin account’s balance or account equity falls below the required maintenance margin level, a margin call will be made to the investor or trader. Because margin positions are collateral-based, accounts can go in the negative. For example, a position is so underwater that all available maintenance margin is gone, and although the broker began a liquidation process to fulfill any open contracts, with slippage and fees the account balance can become negative. However, AMSTERDAX offers negative account protection and will liquidate positions as soon as they are a serious credit risk. 

At some brokerages, investors may be held liable if outstanding balances aren’t paid up and settled. A liquidation occurs when a broker must sell all open positions in order to cover the outstanding margin balance with whatever collateral has been deposited. Investors and traders can lessen position size or deposit more funds to prevent this from happening, and most platforms give at least some warning before this occurs.  

Ultimately, it is up to the trader or investor themselves to manage margin positions appropriately and effectively. Margin accounts should be used by experienced traders and can be quite volatile if not managed properly. The amount of leverage that a broker can offer will vary by jurisdiction as well. 

Margin and leverage are not the same things despite often being confused, especially within the cryptocurrency community. Margin is the deposit that covers a loan, while leverage is the amount of currency or asset you can buy with the deposit. For example, if you are able to buy $10 for every $1 used as margin, the leverage is 1:10 for that transaction. 

Example of using a Margin Account 

An investor wants to take out a position size of one Bitcoin back when the cryptocurrency was trading at $10,000 per coin. If the trader was doing business in a cash account, it would require a full $10,000 deposit. The $10,000 in cash would be traded for one full Bitcoin, allowing the trader to speculate on the movement of price in the markets. If Bitcoin drops $100, the value of the account drops the same. 

With a margin account, a user could deposit $100, and using the power of 100x leverage turn the capital into a $10,000 position equal to one full Bitcoin. With a margin account, it is wise to deposit more capital than the position size the user intends to take, so in this example, a trader would want to deposit more than $100 to allow for the market to move against the position – at least initially, even though the position itself will only be $100 worth. This is because if the trade moves against you, you may get liquidated, only to see a turnaround and work in your favor. 

In both examples, the Bitcoin price rises to $50,000 per coin. In the cash account, the investor earns $40,000 profit with the $10,000 they had at stake. The margin account, however, makes $49,900 profit with only $100 and enough money to cover margin maintenance requirements  

This is the main attraction of the margin account, the ability to make massive gains with very little in the way of capital deposited. The fact that the market moved in your favor means that the gains are realized much quicker. However, you need to be cautious because if Bitcoin were to drop, you would have seen an acceleration of losses. 

What Are the Benefits of a Margin Account? 

Margin accounts are popular for a reason, despite the risk that can often be involved. Risk can be mitigated with proper strategies and in the hands of a skilled trader, a margin account can be powerful. In a sense, one of the biggest hurdles to success lies within the actions of the trader itself. 

Margin accounts enable leveraged trading. Margin money goes a lot further than the money deposited in a cash account thanks to leverage. The bigger position will work both for and against the trader over time. Margin also lets traders long and short, as well as trade derivatives contracts like Futures, CFDs, and Options. 

Margin accounts let traders start small and build up capital over time, rather than requiring massive initial starting capital sizes to turn a reasonable profit. This also in a sense, reduces risk, because less capital is ever put on the line in the first place. Having said that, it is crucial to respect the potential damage that can come with larger position sizing. 

What Are the Risks of a Margin Account? 

Any investment or trade carries a risk of capital loss. Risks in the market increase with the inclusion of cryptocurrencies and other speculative assets. By adding margin accounts into the mix, it can lead to a recipe for total capital loss. However, margin accounts are the most lucrative type of trading account possible, as they offer higher risk and higher rewards. 

Margin accounts put investor capital at risk of a partial or total loss, as investors can get underwater in their positions and owe more than their initial balance. This is why it is crucial to have as much negative balance protection as possible. Here at AMSTERDAX, we monitor credit risks carefully and liquidate them before they get out of hand. 

How to Manage Margin Account Risk 

There are several ways that customers of a margin broker can manage against risk and capital loss, even when relying on powerful trading tools such as leverage. 

The very first way to prevent risk when using a margin account and trading platform is to clearly understand margin requirements and to learn how to use a margin calculator. This allows the trader to understand how much they are risking, in order to keep from overleveraging their account. 

A proper trading strategy and planning that includes fundamental and technical analysis, relying on chart patterns, trading indicators, and market sentiment before entering a position, can improve the chances of success significantly and therefore in turn lower risk. It is important that you have tested this system in either historical scenarios or a demo account. If the system does not perform well in those situations, it certainly will not be in live markets. 

Keeping a larger sum than necessary deposited into a margin account so margin balance remains high, with plenty of room for positions to go wrong and not risk a margin call or liquidation. One of the biggest mistakes that a trader can make is to use all of their available leverage. 

With any type of account, margin accounts carry the normal risk associated with markets moving against the position you have taken. Never invest or trade with more capital than you are comfortably able to afford to lose, to prevent any serious stress from resulting. 

Make sure to keep your emotions well regulated, and even-keeled. Emotional trading in a margin account has led to massive losses for some traders. 

Cash Account vs. Margin Account: What Is the Difference? 

Cash accounts and margin accounts are very different, but once you understand the main differences, you will understand why cash accounts are considered to be advanced. 

You can almost think of a cash account as a debit card versus a credit card. With a cash account, any positions taken will be an exact representation of the amount of USD value (or corresponding fiat currency or cryptocurrency value) of the asset. But with a margin account, much larger position sizes can be taken because the investors are relying on credit provided by the broker. A daily interest rate is also charged just like a credit card. 

With a cash account, you can buy exactly what the amount of cash you currently hold will allow. But with a margin account, this is not the case. In fact, the margin account allows you to trade more than you normally would, but it should be recognized that it is a loan that facilitates this possibility. 

Cash accounts are often reserved for spot trading or spot investing, versus trading CFDs and other derivatives contracts which are typically done with a margin account. Cash accounts are used by investors more than margin accounts, while margin accounts are used by speculators more than investors. 

For example, if an investor places $10,000 into a cash account, the asset’s value would have to depreciate all the way to zero for all cash equivalent positions to be eliminated. With a margin account, the same $10,000 could be lost entirely with one improperly managed position. At the same time, a cash position in most assets would have to be worth millions in order to earn a million in ROI, while a $1 million ROI trade is possible with as low as a $1,000 margin account position, possibly lower, depending on leverage available at each broker.  

Leverage offered and margin requirements vary from platform to platform and can change depending on market conditions. When market volatility is high, for example, a broker might raise margin requirements for the safety of its customers. Brokers or exchanges will generally make an announcement in advance if there are any changes. 

Finally, another way a cash account and a margin account differ is by letting investors and traders profit from both market directions. With cash accounts, customers can only buy and sell assets to and from cash. Meanwhile, margin accounts typically rely on contracts for assets, so traders can long during an uptrend or short during a downtrend, and profit whichever way the trend turns. In short, margin accounts offer more flexibility. 

Leverage 

The term leverage used in finance is often a reference to the amount of money that the trader has borrowed. Leverage gives you the ability to trade much larger positions than you usually would, as you take out a loan from the broker. 

It is worth noting that the trader using leverage has the ability to see an outcome that would be very unlikely in a cash account. This can be good or bad, depending on whether or not the trade has worked out. Leveraged positions can be extraordinarily profitable, or can be extraordinarily damaging, if not managed properly. 

Requirements 

Depending on where you are opening your margin account, there will be some rules that you need to follow. For stocks in the United States as an example, you need to deposit at least $2000 with your brokerage, or 100% of the purchase price, whichever is less. You also need to meet the initial margin requirement, which is 50% of the purchase price. 

In other words, you can borrow 50% of any purchase, but need to provide the other 50% yourself. That being said, at AMSTERDAX we offer much more generous terms in our margin accounts, as leverage can be much larger in the CFD markets. 

Risk

When using a cash account, you face the typical kind of risks that you do with buying any security. If you invest $1000 into an asset, and that asset falls 10%, you end up losing $100. 

However, when using a margin account, your losses are magnified due to the leverage. As an example, if you had that same $1000 to invest, and borrowed another $1000 to buy $2000 in an asset, and the price falls 10%, its value will fall by $200. In other words, in this example, your losses have doubled. 

While margin accounts have a potential for higher returns than a typical cash account, they do come with a substantial downside risk due to the leverage involved. Market volatility could make this especially tricky, and therefore should be monitored in order to protect your trading account. 

In fact, most professional traders will cut back the size of their trading positions when markets are swinging around wildly, making sure to take care of their risks far ahead of worrying about their profits. While leverage can be a great tool, it needs to be respected. 

Conclusion 

A margin account can be quite positive for the trader if they have the correct skills. Furthermore, it allows the profitability to be expanded, beyond what would normally be possible in a standard cash account. 

AMSTERDAX offers built-in technical analysis tools from TradingView allowing traders to get a strong read on the market before ever taking a position. Both long and short positions led traders to profit no matter what direction the market is turning and using stop-loss orders will protect your account.

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Margin accounts simplify the process of “shorting” an asset, as there is no need to go out and borrow it first. The simple pressing of a button allows the trader to get in or out of the market, while all of the financial calculations are done “under the hood.” Simply put, margin accounts are superior to cash accounts in the right hands.