There’s no doubt that trading on margin can help you make money faster if you know how to manage the risks involved. But you must have heard that one of the worst experiences a trader can have is getting a margin call from the broker, so you may be wondering what a margin call is.

A margin call is a call by the broker requesting a trader to deposit additional funds in his account, close some positions, or do a combination of the two, so as to bring his account to the required level. A margin call happens when the value of a trader’s account gets below the broker’s maintenance margin requirement.

As you can imagine, there is a lot you need to know about margin trading and how it works. To learn more, continue reading.

How Does Margin in Trading Work?

Margin Call

Margin Call

It is not all traders/investors that can get a margin call. Margin calls can only happen to those who trade with the brokers’ money — traders who operate margin accounts. But what exactly is margin trading and how does it work

Margin trading is a method of trading whereby an investor borrows money from the broker to complement his own funds when buying or selling a security. To be able to trade on margin, the investor needs to open a margin account with the broker.

Compared to regular trading accounts, a margin account allows a trader to buy securities, such as stocks, options, futures, bonds, and currencies, with funds loaned by a broker. So it grants the trader access to greater trading capital, making it possible for the trader to leverage on bigger positions.

In other words, margin trading is used to amplify trading results so as to realize bigger profits when the trades are successful. This multiplier effect makes margin trading very common in less volatile markets, but stock traders also trade on margin.

What is Needed to Trade With Margin?

For the trader to get a loan from the broker, he is required to deposit a certain amount which serves as a sign of good faith, as well as partial collateral for the loan. This initial deposit is called a margin, and it must not be less than $2,000 for a stock trader. For futures traders, the value is broker-dependent — some brokers may require $5,000 or more, while those that offer mini and micro accounts may accept as low as $500.

In the stock market, trading with a margin account is highly regulated. Apart from meeting the initial minimum deposit of $2,000 required to open a margin account, when placing a trade, you are not allowed to borrow more than 50% of the amount you intend to invest. That is, you must provide a minimum of 50% (initial margin) of the value of the trade you want to initiate.

Example of Margin in Stocks

So if you want to buy $10,000 worth of stocks, you must have at least $5,000 in the account to be able to borrow the other half from the broker. In futures, on the other hand, the margin requirement for opening a trade can be as low as 10% or even 5% of the contract to be traded. For instance, a futures trader can trade a contract quoted at $50,000 with only $2,500 initial deposit — that is a 5% initial margin and 1:20 leverage.

When Do You Get a Margin Call?

Although the initial margin serves as a sort of collateral, owing to the fact that the market is very dynamic, its value can increase or decrease over time. If it decreases below a certain minimum maintenance level, the broker will give the trader a margin call so to top up the account or offset some of his positions to meet the minimum level.

The rule requires that the trader’s equity, as a percentage of the total market value of the trade, must not fall below 25% —  which is the maintenance margin (in contrast to the initial margin of 50% that was needed to enter the trade. This is covered in more depth later). Some brokers may even require a higher value, say 30%, and will place a margin call when the trader’s equity falls below that. Most times, the brokers calculate the stock price below which they can initiate a margin call.

In futures, the maintenance level varies with the exchanges, type of contract (asset types, standard or mini), and the brokers.

Who Sets the Margin Rates?

The regulation of the margin rates — minimum deposit, initial margin, and maintenance margin — depends on the market involved. In over-the-counter markets, like forex, the brokers are at liberty to set the margin rates they want.

In the futures market, the various exchanges (CME, CBOE, and ICE) regulate their margin rates differently. Each exchange stipulates the minimum acceptable levels the brokers can adopt. The brokers can use those values or set higher levels.

For the stock market, the margin rates are regulated by the Financial Industry Regulatory Authority (FINRA) in conjunction with the exchanges (NYSE, NASDAQ, and others). FINRA is an independent, nongovernmental organization that regulates the activities of registered stockbrokers and broker-dealer firms in the US.

Through Regulation T, the Federal Reserve Board sets the initial margin requirement at 50%. The minimum account deposit is set at $2000, while the maintenance margin is at 25%. However, these represent the minimum values — brokers can set theirs higher.

Initial Margin vs. Maintenance Margin

Initial And Maintenance Margin

Initial And Maintenance Margin

When trading on a margin account, there are two types of margins a trader must take care of, namely: initial margin and maintenance margin.

Initial Margin

The initial margin is the part of the cost of a trade which the trader must provide as collateral to be able to borrow the rest from the broker. It is the percentage of the total cost of an investment that a margin account holder must pay for with the cash or marginable securities in the margin account.

The Regulation T of the Federal of the Federal Reserve Board stipulates that a trader must provide at least 50% of the cost of the intended asset or basket of assets. However, this is only the minimum requirement; a broker is at liberty to request more than 50% initial margin.

For instance, assuming a margin account trader wants to buy 2000 shares of Apple Inc., which is trading at $210 per share. The cost of the investment will be $420,000. If the broker demands a 60% initial margin, the trader will only need to have $252,000 in the margin account to buy the $420,000 worth of shares.

Maintenance Margin

Also known as the maintenance requirement, the maintenance margin is the minimum amount of equity a trader must maintain in the margin account. A trader’s equity is the total market value of the investment minus the amount borrowed from the broker. It’s often expressed as a percentage of the total market value of the investment.

The FINRA requires traders to maintain at least 25% of the total market value of the assets in a margin account, but many brokers may require up to 30-40% maintenance margin. When the trader’s equity falls below this value, a margin call is triggered.

Take, for example, a margin account trader buys $20,000 worth of investment after borrowing $10,000 from the broker whose maintenance margin requirement is 30%. At the initial stage, the trader’s equity is 50%.

Trader’s equity% = {(Total market value – Borrowed amount)/Total market value}x100.

= {(20,000 – 10,000)/20,000} x 100 = 50%

If the value of the investment declines to $14,000, for example, the trader’s equity will fall to

= {(14,000 – 10,000)/14,000} x 100 = 28.5%

At this stage, a margin call is triggered because the trader’s equity is less than the broker’s stipulated 30% maintenance margin.

The Benefits of Trading on Margin

A margin account can offer a lot of benefits to a trader. Here are some of the benefits:

  • Increased returns: The main benefit of margin trading is the ability to scale up positions and make more profit when the price is moving in a favorable direction.
  • Ability to diversify: With margin buying, a trader can free more funds to buy different stocks, thereby diversifying his portfolio.
  • Increased cash dividends: Being able to buy more stocks means that the trader can get more dividend income.
  • Convenience: Once a margin account has been approved, getting a margin loan doesn’t require additional paperwork. And as long as the debt doesn’t exceed the maintenance margin, the trader can repay at any suitable time.
  • Low interest rates: Being a loan, a margin loan also incurs interest, but the interest rates are pegged to the federal funds’ target rate. So the interest rate may be cheaper than that of a bank loan or credit card cash advance.
  • Tax-deductible interest rates: The interest on the margin loan may offset your taxable income. Consult with your tax advisor for details about this.
  • Easier participation in an employee stock option plan: Sometimes, employers offer stock options to their employees, providing them with the opportunity to buy the stock at a discount. With a margin account, an employee can use the securities in the account to borrow money to pay for the stock option.

The Disadvantages of Margin Trading

In spite of the benefits, there are many disadvantages of trading on margin, and here are some of them:

Interest rate payment: Being a loan, the interest must be paid, whether the trade is in profit or not. Even when the stock is in profit, the trader may still be at a loss because the returns must exceed the interests before the trader can make any gain.

Increased losses: Just the same way it can increase profits, margin trading can magnify losses and may even lead to getting a margin call from the broker.

The risk of not being able to meet a margin call: When the trader’s equity percentage falls below the maintenance margin, it triggers a margin call. Sometimes traders may not be able to meet margin calls, leading the brokers to liquidate the trades to get their money. When many traders are involved and the volume is huge, forced liquidation can push stock prices down and ever trigger a market crash — 1929 crash, for example.

How Margin Trading Contributed to the 1929 Stock Market Crash

Margin Calls

Margin Calls

During the stock market boom of the late 1920s, there was so much optimism about the stock market that a lot of people bought stocks with borrowed money. All they needed to do then was put down 10-20% of the cost of the stocks (initial margin). So they could borrow up to 80 to 90 percent from the brokers, which were mostly the banks.

At a point before the crash, the majority of investments in stocks were with borrowed money, and more than 40% of all the loans made in the US were in the forms of margin loans for buying stocks. Banks were even using depositors’ funds to buy stocks, neglecting the risks associated with the stock market.

By the 24th of October, 1929 when the stock market was starting to slide, bankers and investors alike found themselves with too much risk exposure. Brokers began making margin calls, but the investors were not able to pay. Since the investors were defaulting on the margin calls, the brokers had to sell the stocks to recover their money.

With the huge volume of sell orders, stock prices plunged further, and there was so much panic. Everybody was trying to sell, and no one to buy. The market slump continued until July 1932; by then, the DJIA has shed about 90% of its value.

What Happens After a Margin Call?

On getting a margin call, a trader can do any of these three things to rectify the margin insufficiency:

  1. Add cash to the account to bring it back to above the maintenance margin level
  2. Deposit some marginable securities that are worth more than the margin deficit
  3. Offset part of the investment and use the proceeds to raise the account to above the maintenance requirement

If the trader doesn’t meet the margin call, the broker can close part or all the open positions to raise the account above the required margin. Additionally, the broker may also charge a transaction fee for closing the open positions.

Conclusion

While margin trading can scale up your profit potentials, it comes with a greater risk of losses. A margin call is one of the nightmares of trading on a margin account. Use with caution!

If you enjoyed this article you might also like our other articles answering common questions traders have!

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