Margin is the use of equity in brokerage accounts as collateral to borrow money or to sell short, to cover the risk of loss, equal to the percentage of equity over the market value of the account. Borrowing money or selling short creates a debit balance on which the broker charges interest and which the account owner must repay. Using margin to buy stock increases potential profits or losses, while also allowing the account owner to sell short, which is legally permitted only in margin accounts.
In the early years of stock exchanges, there were no legal minimum margin requirements. Indeed, during the 1920s, margin requirements were 10% or even less, leading to a highly inflated stock market that eventually crashed in 1929. Many people and businesses were wiped out because they were unable to pay for their stock, causing the bankruptcies of many others. This contagion spread throughout the economy, precipitating the Great Depression. Although many new financial regulations were passed in the 1930s, it was not until 1945 that the United States Federal Reserve instituted minimum margin requirements. Later, stock exchanges and even brokerages also set their own minimum requirements, though their requirements cannot be lower than the Federal Reserve requirement, since the Federal Reserve has national authority to regulate margin requirements.
Interest on borrowed funds — margin interest — is slightly higher than the prime rate banks charge to their best customers. To use margin, the customer must open a margin account with a broker, and the money is borrowed from the broker. The interest rate charged by the broker will depend on how much the broker pays its bank for the money — called the brokers rate — plus whatever amount the broker decides to add. Typically, brokers have a sliding scale of margin interest that depends on the size of the individual trading account, with larger accounts paying lower interest rates than smaller accounts. As of 2021, margin interest rates range from 6% to 9%.
Margin can also refer to the minimum equity required to insure the performance of an obligation. A common example is the margin needed to short stocks. To sell a stock short, you borrow the shares from a broker, then sell them in the market, with the hope of being able to buy the shares back at a lower price. The proceeds of the stock sale are placed in your brokerage account. Although you are not buying the stocks initially, you will still be required to have a minimum equity in your account before you can short the stock to guarantee you will be able to repurchase them later, even if the stock price exceeds the shorted price. You do not have to pay interest nor do you earn any interest on the sale proceeds, because the money is not yours, but is held as security to repurchase the stock.
Like the margin requirement to short stocks, the term margin is also used in futures and forex accounts that specify the amount of cash or cash equivalents, such as U.S. Treasuries, required to guarantee the performance of the futures or currency contract. In futures, the margin requirement is called a performance bond, because it is not borrowed money, but a deposit that guarantees the performance of the contract until settlement. A trader pays no interest on the margin in a futures or forex account — in fact, traders can earn interest by depositing U.S. Treasuries in a futures account to cover the margin requirement.
In futures and forex, the margin requirement is often expressed as a leverage ratio, which is inversely related to the margin percentage:
Margin Percentage = 100 / Leverage Ratio
A 50:1 leverage ratio yields a margin percentage of 100/50 = 2%. A 2:1 ratio yields 100/2 = 50%, which the Federal Reserve establishes as an initial minimum for buying or shorting stocks. Forex brokers often advertise a 50:1 ratio, allowing you to buy $100,000 worth of currency while posting a mere $2,000! Forex brokers can offer these low margin requirements because currency doesn't move with the same magnitude as stocks, especially in a short time, but the large leverage ratio does make currency trading very risky using only 2% margin.
Leverage Ratio = 1/Margin Percentage = 100/Margin Percentage
Most stockbrokers require at least a 50% initial margin, therefore:
Leverage Ratio = 1 / 0.5 = 2
In other words, you can buy twice as many stocks using maximum margin than you can without using margin. Your investment is leveraged for greater profits or even greater losses.
Margin ratios are much smaller in futures than for stocks, where leverage ratios are typically 10:1, which equals a 10% initial margin requirement, but this varies depending on the underlying asset, and whether the trader is a hedger or a speculator — speculators have a slightly higher margin requirement. Forex accounts have an even lower margin requirement, which varies, depending on the broker. Regular forex accounts often allow 50:1 ratios, corresponding to a 2% margin requirement. Forex brokers historically had margin requirements as low as 0.5%, corresponding to a 200:1 leverage ratio, but the National Futures Association increased the minimum margin to 2%, a 50:1 leverage ratio. Forex margin requirements may also depend on the currency being traded, with more frequently traded or stable currencies having the lowest margin requirements.
Margin may be based on rules or on risk. Rules-based margin, sometimes called Reg T margin, the most common type, is calculated according to certain formulas applied to each marginable product. Risk-based margin is calculated according to the risk of the trading portfolio. Hedged positions and safer securities, such as Treasuries, have lower margin requirements. There are no strict legal requirements for risk-based margin; this type of margin is set by the broker.
The rest of this article will discuss using margin for buying or shorting stocks. For shorting stocks, more information is provided in Selling Short, with Formulas and Examples. More information about using margin in futures and for forex can be found here:
Customers requesting margin accounts must 1st receive a risk disclosure document called the Margin Disclosure Statement outlining the risks of using margin and the broker’s own rules on margin accounts. Risks include:
The Margin Disclosure Statement includes a credit agreement, a hypothecation agreement, and a stock-loan consent form. The credit agreement (aka margin agreement) specifies:
The hypothecation agreement stipulates that all securities will be held in street name, in the name of the broker. This part of the agreement allows the broker to use the securities as collateral for any loans and to liquidate the securities if the account equity falls below the minimum required.
The loan consent form allows the broker to loan the securities to others, usually so that they can sell the security short.
Mutual funds and certain new issues cannot be purchased on margin but can be used as collateral after being held for at least 30 days. Brokers may also offer a portfolio margin account for investors with a minimum equity, usually at least $100,000, that offers a lower margin requirement for a portfolio of safer or hedged securities.
FINRA (Margin Account Requirements | FINRA.org) and the New York Stock Exchange require a minimum of $2000 for a margin account. A margin account can be opened with less than that, but any purchases must be paid in full until the account value reaches at least $2000. Securities cannot be sold short in any accounts with less than $2000 and the minimum equity for any short sales in accounts with less than $4000 is $2000. So if you sell short $3000 worth of securities, you must have a minimum equity of $2000. More collateral may be required for accounts holding only 1 security or a large concentration of few securities or if the security is volatile, thinly traded, or low-priced or if some of the collateral becomes restricted, nonnegotiable, or non-marginable.
To use margin for trading, you must open a margin account by signing a margin agreement. The agreement stipulates, among other things, the initial margin requirement as a percentage of the account value, and the minimum margin maintenance percentage of the account value. The margin is determined at the end of each trading day, which determines the amount of margin required for the following trading day. Any securities bought in a margin account are held in the broker's street name, and the margin agreement usually gives the broker the right to lend the securities out for a short sale.
Margin trading is governed by the Federal Reserve, and other self-regulatory organizations (SROs), such as the New York Stock Exchange and the FINRA. Regulation T, promulgated by the Federal Reserve, requires that the minimum deposit be $2,000, and that the initial margin percentage be the greater of $2,000 or 50%. Note that the initial margin requirement must be satisfied before purchasing or selling short any securities, every time when a position is opened.
There is also a minimum maintenance margin requirement of 25% for long positions and 30% for short positions. The exchanges or the brokerages can set stricter requirements (sometimes called house margin requirements) than those required by the Federal Reserve if they choose. Most brokerages set the maintenance margin requirement at 30% for both long and short positions. More volatile or riskier securities often have higher margin maintenance requirements and the maintenance percentage may even increase if a stock's volatility increases. Equity above the maintenance requirement is sometimes called maintenance access or house surplus.
To summarize, the initial margin is the required minimum equity required to open a new position, while the maintenance margin is the required minimum equity to maintain current positions.
Qualified retirement plans, such as IRA accounts or 401(k) accounts, and custodial accounts are not legally permitted to allow margin trading.
Regulation T specifies which securities are marginable and which are not, and which securities may serve as collateral. Marginable securities may be used as collateral in a margin account, but non-marginable securities cannot be bought on margin nor be used as collateral. Some securities may be bought on margin, but cannot be used as collateral. Securities purchasable on margin and usable as collateral include:
Securities that are not purchasable on margin nor can be used as collateral include:
Exempt securities, such as United States Treasuries, government agency bonds, and municipal bonds, are not subject to Regulation T but are subject to maintenance requirements.
The margin ratio cannot be less than the maintenance margin rate. If the margin ratio falls below 50%, but remains above the maintenance margin requirement, then the account will be restricted. No additional securities can be bought or sold short in a restricted account, unless the trader deposits additional cash or securities to increase the margin level to at least 50%.
The available margin will depend on the price of the securities. If margin is used to buy securities, then the amount of margin increases with the market value of the securities, but the amount of margin for shorted securities is inversely related to the price of the shorted securities, decreasing as security prices increase, and vice versa.
If the equity does drop below the maintenance margin requirement, then your broker will issue a margin call, requesting that additional cash or securities be deposited so that the margin ratio of your account equals at least the minimum required. If the margin call is not satisfied within the time allotted, the broker will sell enough securities purchased on margin and/or repurchase the shorted securities at the market to bring the margin ratio to the minimum maintenance margin requirement. Your broker is not required:
Moreover, your broker can raise its minimum requirements at any time, without notifying you beforehand.
To reduce the risks of day trading, both for the trader and for the broker, FINRA has established special rules for margin accounts, effective since September 28, 2001, that applies to all securities in the account, including non-marginable securities, such as options, and regardless of whether leverage is used. A much higher minimum equity of $25,000, in cash or securities, is required for day trading accounts, though brokers can require higher amounts. This minimum margin requirement applies to what FINRA defines as a pattern day trader, a trader who trades more than 4 times within 5 business days and the day trading activities constitute more than 6% of the total trading activity within the same period.
The minimum equity must be in the account the day before any day trades and maintained at all times. Only the equity in the account is the measure of whether the equity satisfies the statutory minimum. Funds in any other accounts, even with the same broker, cannot be used to cross guarantee the minimum equity requirement. So any funds in a savings or checking account at the same broker cannot be used to satisfy the minimum equity requirements. If the minimum equity falls below $25,000, then day trading will not be permitted until the minimum is restored. Any funds used to satisfy the minimum equity requirement must remain in the day trader's account for 2 business days after the day when the deposit was required, when any stock trades (T+2) when the deposit was required must be settled.
The day trading margin requirement is based on the day trader's largest open position during the day rather than the open positions at the end of the day, since day traders, by definition, close all of their positions before the end of the day
Free riding is also prohibited, where the trader sells the security before paying for it. The broker is required to place a 90-day freeze on the account if the trader violates this prohibition.
A pattern day trader can trade up to 4 times the equity in excess of the maintenance margin requirement as of the close of the previous business day; otherwise, a margin call will be issued, requiring the trader to meet the margin call within 5 business days; meanwhile, day trading will be restricted to 2 times the maintenance margin excess, including trades already outstanding. If the day trading margin call is not satisfied by the 5th business day, then the account will be further restricted to cash only trades for 90 days or until the margin call is satisfied.
The brokerage may designate a trader as a pattern day trader if it is reasonable to do so. Once a trader is designated as such, then the brokerage firm will code the account accordingly, and that designation will persist, even if the trader stops day trading, until the trader contacts the brokerage firm to get the designation removed and also ceases to be a pattern day trader.
The most general definition of margin, one covering both buying and shorting securities, is the ratio of the equity of the account divided by the value of the securities. The equity of the account is simply what is left when the debit balance is paid in full and the shorted stocks have been repurchased and returned to the lender.
Margin accounts are marked to market at the end of each day. Margin interest is charged on the debit balance (DB), also called the debit register (DR), which is adjusted for any changes at the end of each trading day.
Debit Balance = Debit Register = Cash Borrowed + Margin Interest
For long positions:
Equity = Cash + Long Market Value (LMV) – Debit Balance (DB)
Borrowed money must be repaid, so the amount borrowed plus the accrued margin interest is a debit to the account.
Margin = Equity / Value of Securities
A complement to margin is the loan value, the amount you may borrow based on the initial margin requirement.
Loan Value = 100% – Initial Margin Requirement
The main reason to borrow money to buy securities is for financial leverage. Financial leverage can increase investment returns or magnify losses. The potential for greater losses causes traders to become more emotional in their trading decisions, which may cause excessive trading, greater transaction costs, and it may cause bad trades when emotion overrules reason. Furthermore, margin interest continually accrues on debit balances, continually lowering returns for buy-and-hold investors.
Another major disadvantage to using margin is that the trader potentially loses some control over the account. If purchased stock drops too much, enough to cause the account to drop below the minimum maintenance requirement, then the broker has the right to sell the stock before notifying the customer. For a short sale, the broker or the lender of the securities have the right to demand the shorted securities back at any time, potentially forcing the repurchase of the securities, even before the trader is notified.
If the margin ratio increases because purchased securities have increased in value or because shorted securities have decreased in value, then the trader gains excess equity (EE) that can be used to purchase or short additional securities.
Excess Equity = Equity − Required Regulation T Equity
Buying power is the market value of securities that can be bought or sold short.
Buying Power = Equity / Initial Margin Requirement
If the initial margin requirement is 50%, which is what most brokers require, then:
Buying Power = Equity / 0.5 = Equity × 2
When a long position increases or a short position decreases, buying power is increased by the increase in excess equity divided by the initial margin required to open a new position. If the initial requirement is 50%, though brokers can set it higher, the increase in buying power is double the increase in excess equity.
Additional Buying Power = Excess Equity / Initial Margin Requirement
Since most brokers set the initial margin requirement to the initial Regulation T requirement of 50%, additional buying power can be defined thus:
Additional Buying Power = Excess Equity / 0.5 = Excess Equity × 2
Limits on Buying Power: Buying Power ≤ Equity − Minimum Maintenance Requirement
Short sales can only be made from a margin account. A margin account can have no less than $2,000 of equity, the federal minimum requirement. Typically, a margin account allows the account holder to borrow up to 50% of the equity in the account for the purchase of new securities. There is also a maintenance requirement of 30% of the equity, though brokers can set it higher. (By contrast, the minimum maintenance requirement for long positions is 25%, though most brokers set it to at least 30%.) If the value of the equity drops below the minimum amount, then the broker issues a margin call. The investor must send more cash or other equity, or the broker will sell enough of the securities, to increase the total equity back to the minimum. However, while the equity is less than 50%, the account will be restricted, meaning that the account owner cannot buy more securities or sell securities short until the equity is increased to at least 50%.
The margin and the margin maintenance requirement are specified by Regulation T, enacted by the Federal Reserve Board. Currently Regulation T requires an initial deposit of $2,000 or more for a margin account, and, initially, the greater of $2,000 or 50% or more as cash or eligible securities as security for any borrowing to buy securities. As applied to a short sale, the investor must initially have at least 50% of the current market value of the shorted security in equity. Brokers may establish more stringent requirements.
In a short sale, money is deposited into the short seller's account, but this money is borrowed, because they are the proceeds of borrowed shares that were sold, and therefore, this money earns no interest for the account holder. Thus, instead of securities, the short seller has borrowed money in his account, subject to the same margin restrictions as buying stock. The amount of short sales proceeds doesn't change after the sale, but the price of the borrowed security does, and margin requirements is tied to the price of the shorted security, not the money in the account, because, eventually, the shorted securities must be bought to replace the borrowed shares. Therefore, the current margin of the account depends on the current market price of the shorted security because the short seller has a legal obligation to repurchase the securities to return them to the lender.
The proceeds of the short sale along with the 50% of equity required to initiate the short sale is placed in a special account called the credit register (CR) or the credit balance (CB). The credit balance does not change with the value of the shorted security, but the equity does.
Credit Balance = Cash Received from Short Sale + 50% Reg T Deposit Requirement
So to sell short $10,000 worth of securities, you must deposit $5000, so your credit balance will equal the $10,000 received from the short sale + the 50% deposit required by regulation T, equaling a total of $15,000. The equity of a short account = the credit balance minus the current market value of the shorted security (SMV):
Equity = Credit Balance − Market Value of Shorted Security
In the previous example, the equity when the securities were sold short equals the credit balance of $15,000 minus the $10,000 market value of the shorted security for a total equity of $5,000.
The short seller is also obligated to pay any dividends to the shareholder of the borrowed stocks, and since neither the lender nor the short seller owns the shorted stock, neither receive the dividends paid by the corporation, but the lender is still entitled to dividend payments, so the short seller must pay what is known as substitute payments in lieu of dividends to the stock lender. The broker pays this automatically from the short seller's account, which decreases the short seller's equity and margin.
If you deposit $5,000 and sell 1,000 shares of XYZ stock short for $10 per share, then there is $15,000 in your credit balance in your account, but your equity is still $15,000 - $10,000 = $5,000, which is, of course, what you initially deposited.
If XYZ price rises to $12 per share, then your equity = $15,000 - $12,000 = $3,000.
If XYZ price drops to $8 per share, then your equity = $15,000 - $8,000 = $7,000.
To calculate margin, just divide the equity by the market value of the shorted security:
Margin = Equity / SMV = Credit Balance - SMV / SMV
(SMV = Market Value of Shorted Security)
You open a margin account and deposit $5,000. You sell short 1,000 shares XYZ stock for $10 per share. The proceeds of the sale, $10,000, + the required margin deposit of $5,000 is your credit balance, for a total of $15,000. However, you still only have $5,000 of equity in your account, because the $10,000 of short-sale proceeds is from borrowed securities.
Scenario 1 — The stock price declines to $6 per share, so the 1,000 shares that you sold short is currently worth $6,000. Thus:
Thus, this short sale would be profitable if you repurchased the shares now to cover your short, for a net profit of $4,000 minus brokerage commissions and any dividends paid while the stock was borrowed.
Scenario 2 — The stock price rises to $13.00 per share, thus it will cost you $13,000 to repurchase the shares now.
Because your current margin is now less than 30%, you will be subjected to a margin call. If you decide to repurchase the shares now to cover your short, your net loss will be $3,000 plus brokerage commissions and any dividends paid while the stock was borrowed.
See Selling Short, with Formulas and Examples for more information about selling short.
A special memorandum account (SMA) is a designated portion of a margin account holding the excess equity of the margin account. Excess equity is the amount by which your equity exceeds the total maintenance requirements for all positions held in your account and increases when the market values of long positions increase or of short positions decrease.
The SMA records the amount of margin credit extendable to clients under the rules of Regulation T as governed by the Federal Reserve. SMA balances, calculated by the broker at the end of each trading day, determine the amount of funds withdrawable from the account or that can be applied to new margin transactions. Without the SMA, security positions would have to be closed to create the cash to open new positions.
SMA = Equity – Initial Margin Requirement
Buying power in terms of the SMA + cash not required as margin:
Buying Power = (Cash + SMA) / Initial Margin Requirement = (Cash + SMA) / 0.5
The SMA is increased by:
The SMA is decreased by:
Option exercises and assignments are treated as trades.
The SMA is not affected by:
SMA Daily Changes = Prior Day SMA ± Change in Cash ± Initial Margin Requirements of New Trades
Although SMA increases with the value of short and long positions, it does not decrease if the market value of those positions decline. The SMA only increases by the initial margin percentage of the increases of the market value of the accounts. So if the initial margin requirement is 50% and the market value of the account increases by $10,000, then the SMA will increase by 50% × $10,000 = $5,000. However, the account equity cannot fall below the minimum maintenance margin requirement. Moreover, the SMA can never be negative; otherwise, the broker may liquidate securities or positions if the SMA is negative at the end of the trading day.
The SMA is always equal to the greater of the excess equity of the account or the SMA already in the account. So the SMA may be more than excess equity and can exceed 0 even if there is no excess equity in the account. Nonrequired cash deposits, which are not required for margin, reduces the debit and is credited to the SMA. If the nonrequired deposit is of marginable stock, then the stocks loan value is credited to the SMA., which is half the value of a cash deposit. The proceeds of a stock sale also increase SMA by 50% of the proceeds. SMA can even be used even in a restricted account, but only if the account value does not drop below the minimum required. SMA can be used to buy securities, but because the SMA is a line of credit, the entire purchase price of the stock increases the debit balance by the same amount. Thus, an SMA at $20,000 can be used to buy $40,000 worth of stock, which increases the debit balance by $40,000. So the buying power of SMA is 2 to 1. However, as a line of credit, the SMA cannot be used to meet a maintenance margin call.
Positive Adjustments to SMA
Negative Adjustments to SMA
To determine the minimum maintenance requirement, excess equity, SMA, and the buying power of combined accounts, accounts with both long and short positions, calculate each separately for the long and short position, then combine the results. The equity is calculated:
Equity of Combined Accounts = Long Market Value + Credit Balance – Debit Balance – Short Market Value
There are 3 examples in the following table for calculating equity, required margin, margin percentage, excess equity, SMA, and buying power for long, short, and combined positions. The 1st set of columns shows the long position, where $20,000 is initially deposited to purchase $40,000 worth of securities. Then the LMV of the securities increases by $10,000, then decreases my $20,000, calculating the margin characteristics for each position. Then this is repeated for a short position in the 2nd set of columns. The final set of columns shows the combined position of both accounts, showing how the margin characteristics change as a value of both sets of securities changes.
Assumptions for these examples:
| Long Positions | Short Position | Combined Position | |
|---|---|---|---|
| Initial Long Position | Initial Short Position | Initial Combined Position | |
| 1 | $20,000 - Deposit $20,000 | $20,000 - Deposit $20,000 | |
| 2 | Buy $40,000 of Securities | Sell Short $40,000 of Securities | |
| 3 | $20,000 - Debit Balance | $60,000 - Credit Balance | |
| 4 | $40,000- Long Market Value | $40,000 - Short Market Value | $80,000 - Combined Market Value |
| 5 | $20,000 - Equity | $20,000 - Equity | $40,000 - Equity |
| 6 | $20,000 - Required Margin | $20,000 - Required Margin | $40,000 - Required Margin |
| 7 | 50.00% - Margin % | 50.00% - Margin % | 50.00% - Margin % |
| 8 | $0 - Excess Equity | $0 - Excess Equity | $0 - Excess Equity |
| 9 | $0 - SMA | $0 - SMA | $0 - SMA |
| 10 | $12,000 - Minimum Maintenance Requirement | $12,000 - Minimum Maintenance Requirement | $24,000 - Minimum Maintenance Requirement |
| LMV Increases by $10,000 | SMV Increases by $10,000 | LMV and SMV Increase by $20,000 | |
| 11 | $50,000 - Long Market Value | $50,000 - Short Market Value | $100,000 - LMV + SMV |
| 12 | $30,000 - Equity | $10,000 - Equity | $40,000 - Equity |
| 13 | $25,000 - Required Initial Margin | $25,000 - Required Initial Margin | $50,000 - Required Initial Margin |
| 14 | 60.00% - Margin % | 20.00% - Margin % | 40.00% - Margin % |
| 15 | $15,000 - Minimum Maintenance Requirement | $15,000 - Minimum Maintenance Requirement | $30,000 - Minimum Maintenance Requirement |
| 16 | $5,000 - Excess Equity | $0 - Excess Equity | $5,000 - Excess Equity |
| 17 | $5,000 - SMA | $0 - SMA | $5,000 - SMA |
| 18 | $10,000 - Buying Power | $0 - Buying Power | $10,000 - Buying Power |
| LMV Decreases by $20,000 | SMV Decreases by $20,000 | LMV and SMV Decrease by $40,000 | |
| 19 | $30,000 - Long Market Value | $30,000 - Short Market Value | $60,000 - LMV + SMV |
| 20 | $10,000 - Equity | $30,000 - Equity | $40,000 - Equity |
| 21 | $15,000 - Required Initial Margin | $15,000 -Required Initial Margin | $30,000 - Required Initial Margin |
| 22 | 33.33% - Margin % | 100.00% - Margin % | 66.67% - Margin % |
| 23 | $9,000 - Minimum Maintenance Requirement | $9,000 - Minimum Maintenance Requirement | $18,000 - Minimum Maintenance Requirement |
| 24 | $0 - Excess Equity | $15,000 - Excess Equity | $15,000 - Excess Equity |
| 25 | $5,000 - SMA | $15,000 - SMA | $20,000 - SMA |
| 26 | $1,000 - Buying Power | $21,000 - Buying Power | $22,000 - Buying Power |
In the above table, 3 sets of examples are shown side-by-side, the first side shows long positions, the 2nd side shows short positions, both using the same initial deposit of $20,000, and the 3rd set showing the combined position if $40,000 were deposited, then opening the long and short positions of the previous 2 sets. The 1st set of rows shows the long or short market values, equity, required margin, margin %, excess equity, and SMA. The next set of rows show what happens when the market value of the securities increases by $10,000; the last set of rows show how the other variables change when the market value of the securities decreases by $10,000.
Restricted accounts are accounts with less equity than required by the initial margin requirement, but more than the minimum maintenance requirement. Because the initial margin requirement must be satisfied whenever new positions are opened, the account owner must deposit more equity before opening new positions. The following rules apply to restricted accounts:
The margin maintenance requirement requires that the margin ratio never drop below this requirement. If the margin ratio drops below this, then a margin call will be issued, requiring you to provide enough equity to bring the margin back up to the minimum maintenance margin requirement, at least 25% for long positions and 30% for short positions, or, if higher, your broker's minimum margin requirement. Most brokers set the minimum maintenance margin requirement at 30% for both long and short positions. The margin call must be satisfied usually within 4 business days, but this could be a much shorter interval especially for short trades that need to be closed quickly. If the amount needed to satisfy the margin call does not exceed $1000, then the broker may choose to add it to the customer’s debit balance. At what account value will a margin call be issued?
For long positions, a maintenance call will be issued when the equity/long market value (LMV) is less than the maintenance margin call. If the maintenance margin requirement is 25%, then a margin call will be issued when the equity declines to less than 1/4 of the LMV. If the maintenance margin is 30%, that a margin call will be issued when the equity declines to less than 30% of the LMV.
First, we consider the use of margin for buying securities. We can derive this formula from the formula for calculating the margin.
The maintenance equation for long margin accounts where the minimum maintenance is 25% = debit balance / .75 = debit balance × 4/3. If the minimum maintenance percentage is 30%, which is common, then the maintenance amount = debit balance / .7 = debit balance / (1 − .3).
You deposit $5,000 and borrow $5,000 to buy $10,000 worth of securities. If the maintenance margin requirement is 30%, what is the value of the securities that will trigger a margin call?
Security Value Triggering Margin Call = $5,000 / (1 − .30) = $5,000 / .7 = $7,142.86
Hence, a margin call will be issued if the value of the securities drops below $7,142.86. To verify the answer, plug this account value into the margin formula to see if it comes out to the maintenance margin percentage:
The formula for calculating the value of securities that will elicit a margin call for shorted stock can be derived from the formula for calculating margin:
Thus, the short account value triggering a margin call is calculated thus:
Margin Call Value = Credit Balance / ( 1 + MMR )
You open a margin account and deposit $5,000. You sell short 1,000 shares XYZ stock for $10 per share. The proceeds of the sale, $10,000, is deposited in your account for a credit balance of $15,000. The margin maintenance requirement is 30%. Therefore, the margin call value = 15,000/(1 + .3) = 15,000/1.3 = $11,538.46, equal to a price per share of $11,538/1,000 = $11.54(rounded) per share. So a margin call will be triggered when the price of the shorted security rises to $11.54.
To verify, substitute $11,538.46 into the margin formula for shorted stock, and find that (15,000 − 11,538.46)/11,538.46 = 0.30 = 30%, the margin maintenance requirement. Note that if any dividends were paid out, this must be subtracted from the account value.
Margin increases the rate of return on investment, if the investment is profitable, but increases losses, if not. Furthermore, transaction costs, margin interest, and any dividend payments for shorted stock subtract from profits but add to losses. Dividends received from purchased stock will increase profits and reduce losses. For a purchase, the rate of return is determined by the following equation:
Long Rate of Return = ( Stock Sale Price + Dividends Received – Stock Purchase Price – Margin Interest ) / Stock Purchase Price
For instance, if you purchased $10,000 worth of stock with cash and the stock rises to $12,000, then your return on investment is:
Rate of Return = ($12,000 + 0 − $10,000 − 0 ) / $10,000 = $2,000 / $10,000 = 20%
If instead of paying cash for the stock, you pay $5,000 cash and use $5,000 of margin, then your rate of return, ignoring margin interest to simplify things:
Rate of Return = $2,000 / $5,000 = 40%
As you can see, using the maximum amount of margin almost doubles your rate of return if the holding period is short enough to keep margin interest negligible. From this example, you can also clearly see that if the stock value decreased by $2,000 instead of rising, then there would be minus signs in front of the rates of return. Furthermore, margin interest increases potential losses and subtracts from potential profits. To illustrate, if your broker charges 6% annual margin interest and you hold the stock for 1 year, then your broker will charge $300 of interest for the $5,000 you borrowed for 1 year. Thus, the rate of return if stock is sold for $12,000 is:
Rate of Return = ($12,000 − $10,000 − $300) / $5,000 = $1,700 / $5,000 = 34%
If the stock is sold at a loss for $8,000:
Rate of Return = ($8,000 − $10,000 − $300) / $5,000 = −$2,300 / $5,000 = −46%.
The longer the margin is borrowed, the more margin interest will decrease any potential profits and increase potential losses. Note also that the loss percentage greatly exceeds the gain percentage for the same $2,000 change in share price.
Note that the equation for shorted stock would be slightly different, since, as a short seller, you must pay any dividends to the lender of the stock that the lender would have otherwise received, but you do not have to pay margin interest. However, you do have to post enough equity to satisfy the initial margin requirement, typically equal to ½ of the value of the shorted stock. Thus, the equation for the rate of return for the short seller is:
Short Rate of Return = ( Stock Sale Price – Dividends Paid – Stock Purchase Price ) Initial Margin Requirement
Using margin is risky. Sometimes stock prices drop so fast, there is no time for margin calls, so the broker is forced to sell margined stocks at low prices, potentially devaluing an account to zero or even less! A good example was provided by the Great Recession of 2008. During the week ending October 13, 2008, the average stock price plunged 18%, forcing many investors who bought stock on margin to sell, which exacerbated the steep decline. Consider these examples reported in this New York Times article, Margin Calls Prompt Sales, and Drive Shares Even Lower:
A primary risk of using margin is forcing you to sell at the very time when losses will be large. And since other investors will also be forced to sell in the declining market, the market declines even further. When the stock market starts declining, it is best to sell some stock to lock in gains and to pay off margin; otherwise you will be forced to sell low after you bought high, which is the simple formula for losing money!
There are 2 disadvantages to holding stocks in a margin account, which are often lent out to short sellers:
Worse, the borrowers of the stock, often short-sellers, can vote against the corporation's interest to put downward pressure on the stock price, so as to increase short-selling profits — thus, voting against the interests of the true stock owners.
A possible scenario is for a hedge fund, which frequently profits from short selling, to borrow the shares right before the record date — usually 30 days before the vote, and vote in its own interests. Delaware law, which governs most large companies because they are incorporated in that state, gives voting rights to whomever happens to have the stock on the record date. Often, the beneficial owners of the stock are unaware of the lending, and that their right to vote has been transferred to someone else.
Sometimes, because of inadequate accounting, both actual stockholders and the borrowers vote, leading to overvoting, which the New York Stock Exchange had found to be a frequent occurrence in some instances.