In the previous section, we discussed the two restrictions imposed on the amount you can borrow. First, the initial margin, which is the initial amount you can borrow. Second, the maintenance margin, which is the amount you need to maintain after you trade. These amounts are set by the
Federal Reserve Board, as well as your brokerage. Individual brokerages can have stricter limits, but the Federal Reserve Board sets a minimum initial margin of 50% and a maintenance margin of at least 25%.
Our focus in this section is the maintenance margin. In volatile markets, prices can fall very quickly. If the equity (value of securities minus what you owe the brokerage) in your account falls below the maintenance margin, the brokerage will issue a "
margin call". A margin call forces the investor to either
liquidate his/her position in the stock or add more cash to the account.
Here's how it works. Let's say you purchase $20,000 worth of securities by borrowing $10,000 from your brokerage and paying $10,000 yourself. If the market value of the securities drops to $15,000, the equity in your account falls to $5,000 ($15,000 - $10,000 = $5,000). Assuming a maintenance requirement of 25%, you must have $3,750 in equity in your account (25% of $15,000 = $3,750). Thus, you're fine in this situation as the $5,000 worth of equity in your account is greater than the maintenance margin of $3,750. But let's assume the maintenance requirement of your brokerage is 40% instead of 25%. In this case, your equity of $5,000 is less than the maintenance margin of $6,000 (40% of $15,000 = $6,000). As a result, the brokerage may issue you a margin call.
If for any reason you do not meet a margin call, the brokerage has the right to sell your securities to increase your account equity until you are above the maintenance margin. Even scarier is the fact that your broker may not be required to consult you before selling! Under most margin agreements, a firm can sell your securities without waiting for you to meet the margin call. You can't even control which stock is sold to cover the margin call.
Because of this, it is imperative that you read your brokerage's margin agreement very carefully before investing. This agreement explains the terms and conditions of the margin account, including: how interest is calculated, your responsibilities for repaying the loan and how the securities you purchase serve as collateral for the loan.
