Opening a margin account is certainly not a daunting or complicated process, though trading on margin can be.
Opening a margin account is certainly not a daunting or complicated process, though trading on margin can be. GETTY IMAGES NORTH AMERICA / EDUARDO MUNOZ ALVAREZ

Not having the necessary cash in your account need not necessarily stop you from buying stocks. Many brokers allow customers to open margin accounts, through which you can borrow cash from the brokerage to fund your stock market transactions, typically at a low rate of interest (around 6% to 9%).

Opening a margin account is certainly not a daunting or complicated process. Here's what you'll need to do.

Steps to Open a Margin Account

  1. Submit an application: If you already have an investment account, you can simply add margin trading capability to your existing account. If not, you'll need to do open a margin account with a broker by submitting an application.
  2. Get approved to open the account: Margin trading involves buying stocks with borrowed money. So, the brokerage will likely review your net worth, annual income, and credit history before approving your application; this could mean a hard inquiry into your credit, which can temporarily affect your credit score.
  3. Fund your margin account: Your margin account will need to have a minimum, which is a certain amount of cash that you will need to keep in your account. In the United States, the Financial Industry Regulatory Authority requires investors to have a "minimum margin" of at least $2,000 in order to qualify for margin trading. Keep in mind, however, that some brokers may set a higher minimum margin requirement.
  4. Check your buying power: In the U.S. the Federal Reserve Board mandates that investors finance no more than 50% of a purchase, using margin; at least half must be paid in cash. Brokers may sometimes further limit how much you can borrow on any one transaction, based on your credit history and financial situation.
  5. Make a trade: Trading on margin is quite similar to trading with cash. If you are a first-time margin trader, you may want to limit your trades to a few shares till you get a better hand of the process.
  6. Maintain your account: Once you buy stocks on margin, you'll need to ensure your account has enough cash to meet the maintenance margin, which is a minimum value (in cash and/or securities) you need to keep in your account to continue trading.

How Does Margin Trading Work?

Say you want to buy 100 shares that are trading at $40 apiece. This transaction would cost you $4,000. Now, if you have only $2,000 in your brokerage account, you can buy 50 shares with the cash in your account and buy the remaining $2,000 on margin.

Let's say the stock's price were to increase 25% to $50, giving you a profit of $10 per share. The benefit of the margin strategy is that you reaped this profit but you only put up half the money to do it; you made $1,000 total profit on an investment of $2,000 instead of one of $4,000--effectively doubling your rate of return from 25% to 50%.

So, what's the catch? Basically, it's that if your rate of return can be doubled, so can your rate of loss--if the investment goes down. Let's take the scenario above--only this time, the shares' price drop $10 apiece, from $40 to $30. Now, your holdings would only be worth $3,000, and you still owe the brokerage the $2,000 you borrowed, plus interest. Your broker doesn't share the risks of your investment: It only lends you money to buy it, with the investment acting as collaterial for the loan. If the investment drops in value, the brokerage asks you to put up more money--a margin call; if you can't pay in cash, it'll sell your holdings to recoup what you borrowed.

Margin Trading Strategies

Seasoned margin traders follow certain best-practices to increase chances of success on their trades. Here are some strategies you can follow when you buy stocks on margin.

  1. Do your research: Whether you are buying your stocks with cash or on margin, it's a good idea to do your research beforehand. Consider investing in companies that have a strong financial position. Avoid margin trading to buy stocks of small-cap companies and momentum stocks.
  2. Compare interest rates: As with any loan, you will need to pay interest on the sum you borrow. The interest usually ranges between 6% and 9%. So, before opening a margin account, make sure to compare the interest rates charged by different brokers. You will likely find the margin rate on the broker's website.
  3. Keep your investment period short: If you are buying stocks on margin, it's best to keep your investment period short, typically to under two months. This will ensure you are not exposed to too many stock market ups and downs during the holding period.
  4. Know when to sell: A common mistake that new investors make is holding on to their stocks for too long, hoping for a larger gain or reduced losses. Before you make your first investment, ensure that work out your target price and if the share price goes above this, consider selling it immediately. Similarly, work out how much loss you can take on.

Margin trading is risky, even for the most experienced investors. If this is your first time investing on margin, consider starting small. And never borrow more in margin than you can afford to repay in cash.