An Introduction to Margin and Option Accounts at a Stock Brokerage - dummies

An Introduction to Margin and Option Accounts at a Stock Brokerage

By Paul Mladjenovic

Margin and option accounts allow you to borrow funds for your trades from the stock broker. This newfound credit gives you more leverage so you can buy more stock or do short-selling.

A margin account (also called a Type 2 account) allows you to invest in stock by borrowing money against the securities in the account. Because you can borrow in a margin account, you have to be qualified and approved by the broker.

For stock trading, the margin limit is 50 percent. For example, if you plan to buy $10,000 worth of stock on margin, you need at least $5,000 in cash (or securities owned) sitting in your account. The interest rate you pay varies depending on the broker, but most brokers generally charge a rate that’s several points higher than their own borrowing rate.

Why use margin? Margin is to stocks what mortgage is to buying real estate. You can buy real estate with all cash, but using borrowed funds often makes sense because you may not have enough money to make a 100-percent cash purchase, or you may just prefer not to pay all cash.

With margin, you can, for example, buy $10,000 worth of stock with as little as $5,000. The balance of the stock purchase is acquired using a loan (margin) from the brokerage firm.

Margin is a form of leverage that can work out fine if you’re correct but can be very dangerous if the market moves against you. It’s best applied with stocks that are generally stable and dividend-paying. That way, the dividends help pay off the margin interest.

An option account (also referred to as a Type 3 account) gives you all the capabilities of a margin account (which in turn also gives you the capabilities of a cash account) plus the ability to trade options on stocks and stock indexes.

To upgrade your margin account to an option account, the broker usually asks you to sign a statement that you’re knowledgeable about options and familiar with the risks associated with them.