Margin is capital an investor deposits as collateral to borrow from a brokerage firm. Margin allows investors to buy additional securities by increasing their purchasing power, which creates the potential for higher returns on invested capital. The potential for higher returns also brings higher risk associated with using margin. Purchasing securities on margin uses leverage. Leverage magnifies returns, both positively and negatively.
When buying on margin, an investor is only required to front a percentage of the security’s total cost and is lent the remaining balance from the broker. Assets already held in the account are used as collateral for the loan.
Margin is calculated by subtracting the market value of all assets under ownership by the cost of the security being purchased. To make a margin purchase, an investor must have a margin account and pay interest on the margin loan. The interest rate on the margin loan is referred to as the call money rate.
The amount deposited in the account by the investor is called the margin. The amount borrowed for the margin purchase is called the margin loan and is charged interest based on the call money rate. Typically, an investor pays the call money rate plus a spread for margin loans. The call money rate and the additional spread varies from broker to broker.
The percentage of the security’s total cost that must be deposited varies by security type, broker, and the volatility of the security. Minimum initial margin requirements are set by Federal Reserve Board Regulation T. Brokers may require initial margin above Regulation T minimums. Typically, the more volatile the security, the higher the initial margin requirement. The minimum initial deposit to establish a margin account at most brokerage firms is $2,000.
Initial margin is the percentage of a security’s price that an investor is required to have in cash and/or collateral in their account as margin to purchase a security.
For example, if the initial margin requirement is 50% and an investor wants to purchase $50,000 worth of stock, they must deposit or have at least $25,000 worth of collateral in the account, and the remaining $25,000 could be borrowed from the broker.
The maintenance margin is the amount of capital that must be available in the account to hold positions purchased on margin.
For example, if the maintenance margin is 30%, once a security has been purchased, the investor must continually have available equity in the account to cover at least 30% of the security. The maintenance margin exists to protect the brokerage firm from outsized losses should the underlying security decrease in price.
If the stock price rises and the shares’ value increases to $60,000, the investor could pay back the initial margin of $25,000, with interest, and keep the remaining $35,000 as profit. The leverage provided by margin creates a 40% return on investment, even though the stock only rose 20% in price.
If the value of the purchased security decreases 20% from $50,000 to $40,000, the investor’s equity collateral, not the borrowed funds, absorbs the loss. If the position were closed, the $25,000 loan from the broker is paid off with the asset’s sale, and the investor is left with $15,000, a 40% decline in account value.
If the stock price declines, the value of the investor’s account declines as well, and they may no longer be able to cover the maintenance margin and would receive a margin call.
A margin call occurs when there is not enough margin in an account to cover the broker’s maintenance margin requirements. Margin calls come from the lending brokerage firm and are a request for more funds to be added to the account to offset losing positions.
For example, assume the maintenance margin requirement is 30%. If the equity in the position dips below 30% of the position’s value, the account is subject to a margin call. In the example below, the share price drops from $100 to $70. The margin loan amount remains the same ($25,000) and the account equity absorbs the loss on the shares (now $10,000 from the initial $25,000). The account equity is $10,000 compared to the position value of $35,000. $10,000 divided by $35,000 is 28.57%. Additional equity must be deposited in the account to at least meet the maintenance margin requirement of 30%.
Margin expansion occurs when the underlying security experiences high volatility.
Margin requirements for positions with undefined risk is not static--increased volatility results in higher margin requirements because the underlying security could make above-average price moves. Therefore, the margin requirements on undefined risk positions may increase during periods of high volatility and the investor will need to have more liquid assets available should the price of the stock go against their position.
Portfolio margin takes active positions in the account into consideration when calculating margin requirements. Portfolio margin is used in derivative accounts with futures, options, and swaps. Portfolio margin manages the lender’s risk by consolidating positions of the overall account into a single portfolio risk.
The borrowing capacity for an investor is increased with portfolio margin because of the holistic approach to initial margin calculation. If the portfolio is showing a net profit from live positions, the positive gains can be used to offset losing positions and allows the investor increased leverage to borrow more margin. Portfolio margin makes hedging much less expensive, because it aggregates the entire portfolio, not just singular positions.
Portfolio margin is potentially available to investors with significant investment experience and sufficient account value. For example, an investor may have to pass a test provided by a broker to ensure they understand the risks of portfolio margin and have an account value greater than $100,000.