Margin in investment contexts refers to the collateral that investors must post with their broker when trading securities with borrowed funds. Margin can also be defined as the difference between the total value of an investment and the amount lent by the broker.
Investors use margin when they borrow money from a broker to buy securities, sell securities short, or use derivatives, such as futures and some types of options. This is called margin trading. Margin trading creates leverage, which can magnify gains and losses.
Investors commonly use margin in the form of funds borrowed from a broker in a margin account. Margin accounts allow investors to use their current cash balance or held securities as collateral for a loan with their broker.
Investors buying securities on margin should be aware of the following concepts and terms.
- Minimum margin: This is the initial investment or minimum deposit required by a brokerage for an investor to open a margin account, usually at least $2,000.
- Initial Margin: This is the percentage of a security’s price that investors must collateralize with cash or other securities. Federal Reserve Board Regulation T sets it at 50%, but some brokerages require more.
- Interest: This is the periodic payment, expressed as an annual percentage, that investors must pay to the broker on an ongoing basis for the margin loan.
- Maintenance margin: This is the minimum amount of equity the broker will require investors to maintain when buying securities on margin. The Financial Industry Regulatory Authority (FINRA) sets it at 25%.
If the value of the margined investment falls and the investor’s equity falls below the maintenance margin requirement, the broker will require a deposit of additional funds or sales of securities to repay the loan. This is called a margin call. If an investor does not meet the deposit requirement, the broker has the right to sell securities in his account to meet the requirement without the investor’s approval.
Suppose Trader A deposits a total of $10,000, meeting the minimum margin requirement of $2,000 to open a margin account with a broker.
The broker sets the initial margin requirement at 50%. In this case, Merchant A can borrow up to $10,000 in additional funds, giving him $20,000 in purchasing power. Their maintenance margin as set by FINRA is 25%, or in this case, $5,000.
Trader A can use his $20,000 buying power to buy 200 shares of ABC Co. at $100 per share. Depending on how stocks are trading, there are a few possible outcomes:
1. ABC Co. shares rise to $150 per share. Merchant A’s new account balance is now $30,000. The return is 200% because Trader A only used $10,000 of personal capital, while the stock rose 50%. In this case, the use of margin amplified returns.
2. ABC Co. shares drop to $40 per share. Trader A’s new account balance, which includes his leveraged buying power, is now $8,000. The net worth of the account is now only $4,000, or 50% of the total position in ABC Co. Since the net worth of the account has fallen below the maintenance margin of $5,000, the trader Has now faced a margin call and must deposit funds or sell securities to bring it back. at the top.
Merchant A must also pay an ongoing monthly fee based on an annual interest rate as long as a margin loan is active. This is the amount the broker charges investors for margin loans. Interest rates can vary depending on a variety of factors, including the current federal funds rate, the perceived creditworthiness of the investor, and the risk of the security on margin.
Investors interested in a margin account should speak to their brokerage on a case-by-case basis. By law, brokerages are required to obtain consent before allowing you to open a brokerage account. The broker may ask you questions about your financial situation, your investment knowledge, your risk tolerance and your goals. This is how they can assess your credit risk before deciding whether or not to extend your margin.
During a margin call, brokers will usually send you an urgent notice advising you of the amount you need to deposit to bring your account back above the maintenance margin requirement. If you do not meet this margin call in a timely manner, the broker has the right to sell other securities in your account to meet the margin call or close positions without your approval.