What is Initial Margin?
Initial margin denotes the percentage of the purchase price of a security or basket of securities (purchased on margin) that an account holder must pay for with available cash in the margin account, additions to cash in the margin account or other marginable securities.
According to Regulation T of the Federal Reserve Board, the initial margin is currently set at 50% of the purchase price of a security or basket of securities that can be purchased on margin. However, this regulation is intended as a minimum requirement for equity brokerage firms, who can ask the account holder to deposit more than 50% in cash or other liquid collateral.
How Does Initial Margin Work?
To open a margin account at a brokerage firm, an account holder first needs to post a certain amount of cash, securities or other collateral, known as the initial margin requirement. A margin account encourages investors, traders and other market participants to use leverage to purchase securities with a total value that's greater than the available cash balance in the account. A margin account is essentially a line of credit in which interest is charged on the outstanding margin balance.
Securities in the margin account are paid for with cash loaned to the account holder by the brokerage firm and are designated as collateral. This process allows for magnification of potential profits but also magnifies potential losses. In the extreme event that securities purchased in a margin account decline to zero value, the account holder needs to deposit the full initial value of the securities in cash or other liquid collateral to cover the loss.
- Initial margin requirements are different than maintenance margin requirements, which may also change in reaction to market volatility.
- Fed regulations currently require that initial margin is set at a minimum of 50% of a security's purchase price.
- Initial margin requirements are set by exchanges in the futures markets.
Example of Initial Margin
As an example, assume an account holder wants to purchase 1,000 shares of Facebook, Inc. which is quoted at $200 per share. The total cost for this transaction in a cash balance account would be $200,000. However, if the account holder opens a margin account and deposits the 50% initial margin requirement, or $100,000, the total purchasing power will rise to $200,000. In this case, the margin account has access to two-to-one leverage.
Initial Margin & The Futures Markets
For futures contracts, exchanges set initial margin requirements as low as 5% or 10% of the contract to be traded. For example, if an crude oil futures contract is quoted at $100,000, a futures account holder can enter a long position by posting only $5,000 initial margin, or 5% of the contract value. In other words, this initial margin requirement would give the account holder a 20x leverage factor.
During periods of high market volatility, futures exchanges may increase initial margin requirements to any level they deem appropriate, matching the power of equity brokerage firms to increase initial margin levels above those required by Fed regulation.