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What's a margin account?

A margin account is a special account with your brokerage firm that lets you borrow money to pay for a certain percentage of a stock you want to buy.

The brokerage lends you part of the money, charges you interest and holds some of your securities as collateral. The term margin refers to the proportion of the total cost that you must provide. A margin account lets you use leverage to buy more stock than you would be able to buy if you just used your own money. If a stock's price rises, this multiplies your profits.

Here is an example in which the stock price rises after you buy. Assuming you have a 50% loan limit, you could buy $10,000 worth of a stock, but pay just $5,000. Your brokerage lends you the money for the rest. If the price of the stock rises by 10%, to $11,000, you have earned $1,000. That's a 20% gain on your actual $5,000 investment.

Your profits, of course, will be reduced by the interest costs, and by the commission you pay to buy (and later sell) the stock.

The trouble comes, though, if the stock's price falls. Now you are looking at losses that multiply the same way the gains do.

Here's an example in which the stock price falls after you buy. It's the same as the example above, but assume the stock price falls by 10%, to $9,000. You have lost $1,000. That's a 20% loss on your actual $5,000 investment. And if the stock price drops too much, you may also be subject to a margin call from your brokerage. This means you will have to put up more cash or collateral - immediately - so that you maintain margin at an acceptable level. If you can't meet the margin call, the brokerage can sell some of your securities to bring your account back on side.

Margin rules are set by the brokerage industry's self-regulatory organization, the Investment Dealers Association of Canada. Margin limits vary, depending on the price of the stock. If a stock price shifts from one range to another, the margin requirements change. This means you may get a greater margin call than you expect if the price of your stock falls through one of these levels.

For those stocks trading at more than $5 a share that meet the requirements for listing options on them, you can borrow as much as 70% of the value. For those above $2 that aren't option-eligible, the limit is 50%.

You can borrow 40% of the value of shares priced between $1.75 and $1.99 a share, and 20% of those in the $1.50-$1.74 range. No margin buying is allowed for shares trading below $1.50.

Keep in mind that these are maximum loan values. Individual brokerages can set more restrictive limits, as they see fit, since they are offering credit to their clients. Brokerages sometimes tighten the rules for investors who borrow to invest in certain speculative stocks.

Using borrowed money to invest - whether through a margin account or from other sources - carries substantial risks. You shouldn't consider borrowing to invest unless you fully understand and are comfortable with the risks, and have the financial resources to weather losses.