Margin trading is a technique used by investors looking to increase their purchasing power of assets; primarily securities. Investors leverage their capital through margin trading by creating a margin trading account with their investment brokerage. Margin accounts allow investors to receive an agreed upon percentage of capital from their brokerage in the form of a margin loan based on the value of their margin account prior to receiving a margin loan from the brokerage. Margin loans issued by brokerages to margin account holders are collateralized by capital held in the margin account and are subject to interest and fees.
Investors engaging in margin trading are taking what is known as a 'leveraged position' because they are leveraging capital from other investors (the broker) while exposing themselves to the risk of speculating on the future price of acquired assets. Without margin trading, an investor would not be able to purchase the same amount of an asset due to lack of capital.
Margin trading heightens the risk of investing, but also increases the earning potential of investors by gaining access to additional capital. Due to the increased risk associated with margin trading investors need a special brokerage account called a "margin account' to engage in margin trading. The investors equity of their margin accounts are worth the market value of the assets held in the account minus the value of the margin loan from the brokerage, and their margins loans are secured by the value of securities purchased using the margin account.
The following equation demonstrates how the value of margin accounts are calculated: market value of margin account assets — (margin loan + commission fees + due interest) = value of margin account.
The following are the primary reasons people use margin accounts:
- Leveraging capital to increase buying power to capitalize on market opportunities
- Ability to acquire an increased amount of securities on margin
- For consolidating high-interest loans
- For an alternative way of borrowing capital compared to more traditional methods
- For taking advantage of short-term cash solutions
- For overdraft protection
The initial margin refers to the amount of capital an investor has in their margin trading account, and is used to determine the amount of money a brokerage is willing to offer an investor through a margin loan. Traditionally, brokerages require investors to have a 50% margin requirement (total funds in account after loan is issued) in their account for stock purchases and about 10% for trading futures using margin trading. In the United States, initial margin requirements are set by regulation T of the Federal Reserve Board which states investors have an initial margin requirement of 50% and a maintenance margin requirement of 25%.
For example, if an investor has $2500 in their margin trading account the brokerage loans the investor an additional $2500 for purchasing stocks using the investors own $2500 in the margin account as collateral for the margin loan. After the margin loan is given to the investor for margin trading, the investor now has $5000 dollars to invest with instead of $2500.
Minimum margin represents the minimum amount of capital required in a margin account to be edible for margin loans and margin trading. In the United States, the minimum margin requirements of margin accounts is set by the Financial Industry Regulatory Authority's (FINRA) rule 4210 which states investors must have at least $2000, or 100% of the purchase price, in their margin accounts before being eligible to purchase securities on a margin.
The issuers of margin loans (brokerages) reserve the right to make what is known as a 'margin call' if an investors margin account has declined in value past a certain point such as the maintenance margin or minimum margin. Brokerages are not legally obligated to notify the owners of margin accounts if their account equity is below the maintenance margin or minimum margin set by the brokerage, and are able to liquidate assets to meet maintenance margin requirements on behalf of margin account owners.
The margin call may require the owner of the margin account to deposit more money or securities into their account, or the brokerage may sell assets on the behalf of the margin account owner to meet the maintenance margin. Maintenance margins are set by each brokerage independently (typically between 30-40%) so maintenance margins between brokerages vary.
The Financial Industry Regulatory Authority (FINRA) requires investors to have a minimum of 25% of the value of their securities held in their margin accounts. For example, if an investor purchases $10,000 worth of securities purchased with $5000 of their own money and $5000 on margin (the brokers margin loan), and the value of those securities falls to $6500. The equity the investor now holds in their margin account is $1500 ($6500 — $5000 = $1500) which is the equivalent to having 23% of equity in the investor margin account. If this occurs the brokerage is obligated by FINRA to issues a margin call because the investors equity in their margin account has fallen below the 25% threshold.
Brokerages may have different terms of service for margin accounts with concentrated equity positions compared to margin accounts with non-concentrated equity positions. For example, a brokerage may impose a 40% maintenance margin if the margin account has between 70-100% concentrated equity in their margin accounts, while margin accounts with less than 70% concentrated equity may have a maintenance margin requirement of 30%.
Day trading using margins requires the use of day-trading accounts and is subject to higher barriers of entry and different buying power limitations compared to typical margin accounts. Investors day trading on margins are required by the Financial Industry Regulatory Authority (FINRA) to maintain a minimum margin of $25000 of equity in their day trading accounts the day before engaging in any day trading activity. Funds deposited into a margin day trading account must remain in the account for two business days before withdrawal of funds can take place.
Investors are required to maintain a minimum of $25000 (or the maintenance margin set by the brokerage) in their accounts at all times during day trading, and if their account equity falls below $25000 they are obligated to immediately restore their account equity to $25000 before making any more day trades.
Margin calls for day traders trading on margins are issued when margin day traders exceed their day trading buying power limitations set by FINRA. FINRA allows margin day traders to trade four times their maintenance margin excess present in their accounts at the close of business on the day before trading begins. Each brokerage is able to set more strict requirements on maintenance margins for day trading margin accounts than are set by FINRA, and are legally obligated to meet the minimum day trading margin account requirements set by FINRA. If margin day traders exceed their buying power limitations, their brokerage will issue a day trading margin call.
After a day trading margin call is issued the owner of the day trading margin account has up to 5 days to deposit the required funds into their accounts to compensate for exceeding their buying power limitations. During this five day period day trading accounts are permitted to make trades up to two times their maintenance margin excess based on the sum of their daily trading commitment. If investors fail to deposit the necessary funding into their day trading margin accounts by the 5th day after the day trading margin call has been issues, investors will be limited to trading only with their own cash held in their accounts for up to 90 days or until the necessary funding is deposited into their account.
The following organizations are involved in the regulation of margin trading:
- U.S. Securities and Exchange Commission
- New York Stock Exchange
- Financial Industry Regulatory Authority
- The Federal Reserve Bank
