According to mythology, Prometheus stole fire from the gods and brought it down to earth to benefit mankind. Essentially he brought down a gift that can cook our food, heat our homes, and give us light. Human progress probably would not have been possible without it. But the very same gift is also capable of destroying everything progress creates. If we misuse the gift whether in cooking or in heating, it can lead to disastrous results.
Slides for adults
When I opened up a brokerage account earlier this year, I was prompted to pick between a cash account or a margin account. The former was a straightforward option but the latter required some researching. I needed to know exactly how that was different from normal accounts and what the rewards and drawbacks were.
It turns out that margin accounts are a lot like fire from the heavens.
Slides can be fun
If, as an investor, you crave adrenaline, then margin accounts are a good fit. Margin accounts allow you to borrow money from your broker to purchases securities that would otherwise be unaffordable. If shares of ABC were selling for 100 dollars a share, margin accounts allow you to purchase these for 50 dollars out of your own money and have the brokerage pay the rest. If ABC goes up in price to 150 a share and you sell it, you pay the brokerage back the 50 dollars a share they loaned to you (plus fees for loaning you money) but you get to keep how ever many dollars are left out of every share.
So you get to afford securities that would otherwise be out of reach and possibly profit from them handsomely.
Going down and down and down
But if ABC goes down to 25 dollars a share, you still have to pay the brokerage the 50 dollars you originally borrowed, even though the securities are now worth less than what you invested. This is the biggest risk when it comes to margin accounts. It is possible to lose more than what you invest. Even with triple leveraged ETFs, you do not risk as much as with these type of accounts.
Once you start losing money, it becomes hard to go back up to the top of the slide since you cannot wait for ABC to go back to $100. Based on the agreement (usually a signed contract) you have with your brokerage, they can sell your securities if they see that the total amount you have left will not be able to cover the loans you borrowed from them. They are just making sure that they get their money back.
More than just fun and games
Margin accounts can have very satisfying results or it can be your worst nightmare. It can bring light and progress but it can also drop you at the bottom so before choosing this type of account, please make sure that all the risks and rewards are weighed accordingly.
Do you own a margin account? How risky is it really?
(photo: 31417716@N00)
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