Margin Account

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In a margin account, the brokerage firm basically lends you money. However, you are still required to maintain in your brokerage account at least half the value of the stock that you want to purchase. A margin account enables an investor to make money faster, but be warned : It also enables an investor to lose money faster. The process by which this works is known as leverage as discussed earlier in Lesson 6, "Stock Derivatives," whereby additional money or credit is applied to an investor's purchase (or sale) of stock.

Plain English

Leverage is like a seesaw: The farther you get from the center, the greater the movement. The seats on the seesaw will go higher and lower, as will the value of the investment in larger profits and losses.

Say, for example, that you open a margin account with $1,000. You can place a purchase order for $1,986 worth of XYZ stock. "Wait a second," you say. "Where'd that number come from?" First, we're assuming you're still using the same broker as in the cash account example. You're still required to pay the $7 service charge for the purchase. This leaves you $993 with which to buy the stock. Since you have to maintain at least half the price of the stock purchase, the brokerage can lend you only $993, not $1,000 for the purchase.

$993 + $993 = $1,986

Next, let's say that the value of XYZ stock doubles the next day, and your stock is now worth $3,972 ($1,986 + $1,986). You can sell the stock (the sell order will cost you $7 again), give $993 back to the brokerage house, and pocket $2,972. Compare your $2,972 with the $1,979 the investor with a cash account would have made with the same investment ($993 + $993 = $1,986, which is the initial amount invested and the capital gain when the stock value doubled , minus $7 for the sale is $1,1979), and you're ahead of the other investor by $993.

So why isn't everyone using a margin account? On the other side, let's say you still make the initial purchase of $1,986, and the next day the value of XYZ stock drops by half. Your stock is now worth $993 and that's also the amount the brokerage lent you, so you have to repay that amount plus the $7 for the sale order. You are effectively back at zero. The guy in the cash account, though, is still holding stock worth $496.50 ($993 · 2). Not a great day by any standards, but still preferable to owning nothing and being $7 in debt for service charges to boot.

One More Point

Obviously, most real-life examples aren't quite as dramatic or straightforward. Did I mention that the brokerages will also charge you interest on the loan? So even in less dramatic examples, the margin account investor will need to make a higher profit to come out ahead, since the interest charges must be figured into the formula as well.

Finally, certain restrictions apply as to what kinds of stocks can be purchased or sold through margin accounts. These restrictions are usually reserved for the more obscure stocks and therefore don't necessarily prohibit regular day-to-day transactions.

Margin accounts certainly appeal to the risk takers. In addition, they can prove a useful tool for someone who has the resources to back any error, but it is an area best avoided by new investors.

CAUTION

Make sure you directly question your broker about any restrictions before opening a margin account. As with anything dealing with money, make sure you know what you're getting yourself into.

Drips

Direct Reinvestment Plans, or DRIPs, are an ingenious method many companies have developed to make their stock available to individual investors without the use of a broker. The company raises capital funds without having to go through the expense and trouble of issuing new stock and the investor makes out by minimizing or avoiding a broker fee altogether through purchasing stock directly from the company. In addition, many companies will even reduce the stock price from its market price.

DRIPs are designed for investors to accumulate stock in the company by requiring subsequent systematic purchases of the stock. To maximize that result, and because purchases and sales of the stock are handled through the company, redeeming or selling your shares may require a substantially longer period of time.

Most of the larger companies such as Home Depot and the Chase Manhattan Bank, for example, offer DRIPs, although few if any are aggressively advertised. Should you firmly believe the potential of a particular company's merits, check its Web site or contact the company through its main number and ask about the availability and particulars of its DRIP program.

The 30-Second Recap

The minimum amount required to open a brokerage account varies, as do potential perks.
A cash account is a brokerage account in which the investor may purchase stock equivalent to no more than the amount of money available.
A margin account is a brokerage account whereby an investor can purchase stock with money loaned by the brokerage. The amount of the loan cannot exceed the amount of money maintained within the account by the individual investor.
Direct Reinvestment Plans (DRIPs) are programs offered directly from companies whereby potential investors make systematic purchases of the stock in return for absorbed broker costs and reduced share prices.

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