What it is:
How it works (Example):
Let's assume you want to buy 1,000 shares of Company XYZ for $5 per share but don't have the $5,000 necessary to do so -- you only have $2,500. If you buy the shares on margin , you essentially borrow the other half of the money from the brokerage firm and collateralize the loan with the Company XYZ shares. This original loan amount as a percentage of the investment amount is called the initial margin.
If the value of the Company XYZ shares drops and the value of the account holdings falls to 25% (the maintenance margin) of the original $5,000 value (or $1.25 per share), the brokerage firm may make a margin call. Within a few days you must deposit more cash or sell some of the shares to offset all or part of the difference between the actual stock price and the maintenance margin. The broker does this because it has lent you $2,500 and wants to mitigate the risk of you defaulting on the loan.
Margin accounts must follow a margin agreement, which the investor must sign, as well as regulations imposed by the National Association of Securities Dealers, the Federal Reserve, the brokerage itself and the exchanges that the investor will be dealing with.
Why it Matters:
Margin accounts allow investors to make investments with their broker's money. They act as leverage and can thus magnify gains. But they also magnify losses, and in some cases, a brokerage firm can sell an investor's securities without notification or even sue if the investor does not fulfill a margin call . For these reasons, margin accounts are generally for more sophisticated investors who understand and can handle the risks involved.