A margin account lets investors borrow funds from their broker in order to augment the buying power in their account, using leverage. This means that with 50% margin, you can buy $1,000 worth of stocks with just $500 cash in the account—the other $500 being loaned by your broker.
- A margin account allows investors to borrow funds from their broker in order to leverage larger positions with the cash they have available, boosting their buying power.
- A margin call occurs when the value of the account falls below a certain threshold, forcing the investor to add more money in order to satisfy the loan terms from the broker or regulators.
- If a margin call is issued and the investor is unable to bring their investment up to the minimum requirements, the broker has the right to sell off the positions and also charge any commissions, fees, and interest to the account holder.
Minimum margin is the amount of funds that must be deposited with a broker by a margin account customer. With a margin account, you are able to borrow money from your broker to purchase stocks or other trading instruments. Once a margin account has been approved and funded, you are able to borrow up to a certain percentage of the purchase price of the transaction. Because of the leverage offered by trading with borrowed funds, you can enter larger positions than you would normally be able to with cash; therefore, trading on margin can magnify both wins and losses. However, just as with any loan, you must repay the money lent to you by your brokerage.
The minimum margin requirements are typically set by the exchanges that offer various shares and contracts. The requirements change in response to factors such as changing volatility, geopolitical events, and shifts in supply and demand. The initial margin is the money that you must pay from your own money (i.e., not the borrowed amount) in order to enter a position. Maintenance margin is the minimum value that must be maintained in a margin account. The maintenance margin is usually set at a minimum of 25% the value of the securities held.
Note that federal regulations, known as Reg. T, require that for initial margin purchases, a maximum of 50% of the value of securities held must be backed by cash in the account.
A margin call occurs if your account falls below the maintenance margin amount. A margin call is a demand from your brokerage for you to add money to your account or closeout positions to bring your account back to the required level. As an example, assume the $1,000 of shares purchased above loses 3/4 of its value, so it is now worth just $250. The cash in your account has fallen to 3/4 of its original amount, so it has gone from $500 to $125. But you still owe $500 to your broker! You will need to add money to your account to cover that since your shares are not worth nearly enough at this point to make up the loan amount.
A margin call is thus triggered when the investor's equity, as a percentage of the total market value of securities, falls below a certain percentage requirement, which is called the maintenance margin. The New York Stock Exchange (NYSE) and FINRA, for instance, require investors to keep at least 25% of the total value of their securities as margin. Many brokerage firms may require an even higher maintenance requirement—as much as 30% to 40%.
The best way to avoid margin calls is to use protective stop orders to limit losses from any equity positions, as well as keep adequate cash and securities in the account.
Failure to Meet a Margin Call
The margin call requires you to add new funds to your margin account. If you do not meet the margin call, your brokerage firm can close out any open positions in order to bring the account back up to the minimum value. This is known as a forced sale or liquidation. Your brokerage firm can do this without your approval and can choose which position(s) to liquidate. In addition, your brokerage firm can charge you a commission for the transaction(s), and any interest due on the money loaned to you in the first place. You are responsible for any losses sustained during this process, and your brokerage firm may liquidate enough shares or contracts to exceed the initial margin requirement.
Forced liquidations generally occur after warnings have been issued by the broker, regarding the under-margin status of an account. Should the account holder choose not to meet the margin requirements, the broker has the right to sell off the current positions.
The following two examples serve as illustrations of forced selling within a margin account:
- If Broker XYZ changes its minimum margin requirement from $1,000 to $2,000, Mary’s margin account with a stock value of $1,500 now falls below the new requirement. Broker XYZ would issue a margin call to Mary to either deposit additional funds or sell some of her open positions to bring her account value up to the required amount. If Mary fails to respond to the margin call, Broker XYZ has the right to sell $500 worth of her current investments.
- Mary’s margin account net value is $1,500, which is above her broker’s minimum requirement of $1,000. If her securities perform poorly, and her net value drops to $800, her broker would issue a margin call. If Mary fails to respond to the margin call by bringing her delinquent account up to good standing, the broker would force sell her shares in order to reduce leverage risk.