Margin accounts

What Are Margin Accounts?

Margin accounts are brokerage accounts that allow investors to borrow money from their brokerage firm to purchase securities. This borrowed money is known as margin credit or a margin loan, and the securities purchased serve as collateral for the loan. Utilizing a margin account falls under the broader financial category of Investment Products & Services, specifically related to leveraged investing. By extending credit, margin accounts enable investors to control a larger value of securities than their cash capital alone would permit, effectively introducing leverage into their investment strategy.

History and Origin

The practice of buying securities with borrowed money, or on margin, has existed for a considerable time, but its widespread and unregulated use significantly contributed to major financial crises. Prior to the Great Depression, margin requirements were often very low, sometimes allowing investors to put down as little as 10% of a stock's purchase price and borrow the rest. This easy access to credit fueled rampant speculation in the stock market during the "Roaring Twenties." As the market surged, many ordinary individuals, including clerks and cab drivers, participated, often borrowing heavily to purchase shares.¹²

However, this speculative bubble proved unsustainable. When the market began to fall in October 1929, investors faced "margin selling" and banks demanded repayment of loans, triggering widespread panic.¹¹ On "Black Tuesday," October 29, 1929, an estimated $14 billion in stock value was lost, wiping out thousands of investors who had bought on margin and could not meet the demands for additional funds. This event, a pivotal moment in financial history, underscored the profound risks associated with unchecked margin lending. In the aftermath of the 1929 crash, regulatory bodies were established to oversee and impose rules on margin lending, aiming to prevent similar catastrophic market collapses.

Key Takeaways

• Margin accounts allow investors to borrow money from their brokerage firm to buy securities, amplifying potential gains or losses.
• The securities purchased in a margin account serve as collateral for the loan.
• Margin trading involves significant risk, including the possibility of losing more than the initial investment.
• Regulatory bodies like the Federal Reserve Board and FINRA set rules, such as initial and maintenance margin requirements, to manage this risk.
• A margin call occurs when the equity in an account falls below the required maintenance level, necessitating additional funds or asset liquidation.

Formula and Calculation

Understanding the calculations in a margin account involves several key components, notably the initial margin and maintenance margin.

Initial Margin: The initial margin is the percentage of a security's purchase price that an investor must pay with their own funds. The Federal Reserve Board's Regulation T generally mandates that investors can borrow no more than 50% of the purchase price for marginable securities.,¹⁰

Maintenance Margin: This is the minimum amount of equity an investor must maintain in their margin account at all times after the purchase. FINRA rules generally require a maintenance margin of at least 25% of the total market value of securities in the account, though many firms impose higher requirements.⁹,⁸

A margin call is triggered when the actual equity percentage falls below the maintenance margin percentage:

If $\text{Equity Percentage} < \text{Maintenance Margin Percentage}$, a margin call is issued.

Interpreting Margin Accounts

Margin accounts offer investors the opportunity to increase their purchasing power and potentially magnify returns. By using a margin account, an investor can engage in strategies like day trading or short selling, which often require the ability to quickly enter and exit positions or sell borrowed securities. However, this amplified potential for gains comes with a correspondingly higher risk.

The interpretation of a margin account largely hinges on its current equity level relative to the maintenance margin requirements set by regulatory bodies and the brokerage firm. A healthy margin account has sufficient equity to cover potential market fluctuations. Conversely, an account with equity close to or below the maintenance margin indicates heightened risk, as a small adverse price movement could trigger a margin call and potential forced liquidation of assets. Investors must continuously monitor their equity percentage to effectively manage the risks associated with margin trading.

Hypothetical Example

Suppose an investor wants to purchase 100 shares of XYZ stock, currently trading at $50 per share, for a total value of $5,000.
With a cash account, the investor would need to pay the full $5,000.
However, using a margin account, and assuming an initial margin requirement of 50%, the investor would only need to deposit $2,500 of their own funds (50% of $5,000). The remaining $2,500 would be borrowed from the brokerage firm.

Now, let's consider what happens if the stock price drops. Assume the maintenance margin requirement for XYZ stock is 25%.
If the price of XYZ stock falls to $30 per share, the total market value of the 100 shares becomes $3,000.
The investor still owes $2,500 on the margin loan.
The equity in the account is now: $3,000 (Current Market Value) - $2,500 (Margin Loan) = $500.
The equity percentage is: (\frac{$500}{$3,000} \times 100% \approx 16.67%).

Since 16.67% is below the 25% maintenance margin requirement, the brokerage firm would issue a margin call. The investor would then need to deposit additional funds or securities to bring the equity percentage back above 25%, or the firm could force the liquidation of some or all of the securities in the account to cover the loan.

Practical Applications

Margin accounts are widely used by investors seeking to enhance their market exposure or employ specific investment strategy. Beyond simply increasing purchasing power, they facilitate several practical applications:

• Increased Returns (and Risks): Margin can amplify returns when investments perform well, as the investor profits on a larger asset base than their initial capital. Conversely, losses are also magnified.
• Short Selling: Margin accounts are essential for short selling, where an investor borrows securities and sells them, hoping to buy them back later at a lower price. This strategy relies on the ability to borrow shares through the margin account.
• Arbitrage and Hedging: Sophisticated investors may use margin to execute arbitrage strategies or to hedge existing portfolio positions, allowing them to capitalize on price discrepancies or mitigate certain risks.
• Flexibility for Options and Futures: Many options and futures trading strategies require a margin account to cover potential obligations and manage risk management exposures.
• Liquidity Management: For investors who prefer to keep their cash readily available, a margin loan can provide temporary liquidity to seize investment opportunities without liquidating other assets.

The use of margin is subject to stringent rules. The Federal Reserve Board's Regulation T governs the amount of credit brokers and dealers can extend, setting initial margin requirements.⁷ Additionally, the Financial Industry Regulatory Authority (FINRA) establishes detailed margin requirements for broker-dealers, including minimum equity levels that customers must maintain. For example, FINRA Rule 4210 outlines specific percentages for initial and maintenance margin requirements, which can vary based on factors like the type and volatility of securities.⁶,⁵

Limitations and Criticisms

While margin accounts offer opportunities for amplified returns, they come with significant limitations and criticisms primarily related to amplified risks and potential for substantial losses.

One of the most critical limitations is the risk of losing more money than initially invested. When securities bought on margin decline in value, the investor is still responsible for repaying the full margin loan plus interest rates. If the account's equity falls below the maintenance margin, a margin call is triggered, demanding additional funds. If the investor cannot meet this call, the brokerage firm has the right to sell securities in the account without prior notice, often at unfavorable market prices, to cover the loan. This forced liquidation can lead to substantial and rapid losses, even if the investor believes the market will eventually rebound.⁴,³

Furthermore, brokerage firms retain the right to increase their own margin requirements at any time, often without advance notice, depending on market conditions or the volatility of specific securities. This can lead to unexpected margin calls, placing investors in a precarious position. FINRA has issued investor alerts specifically warning about the dangers of trading on margin, emphasizing that investors may underestimate the risks and misunderstand the operation of margin calls.² Critics often point to historical events, such as the 1929 stock market crash, where excessive margin lending was a significant contributing factor to widespread financial devastation.¹ The inherent leverage in margin accounts, while appealing for potential gains, is a double-edged sword that can lead to rapid erosion of capital.

Margin Accounts vs. Cash Accounts

The primary distinction between margin accounts and cash accounts lies in the ability to borrow funds for investment.

A cash account requires investors to pay the full purchase price of all securities at the time of the transaction. There is no borrowing involved, and therefore, no interest charges, no margin calls, and no risk of forced liquidation due to insufficient equity from a loan. This type of account is generally considered lower risk, as an investor can only lose the amount of money they have deposited.

Conversely, a margin account permits investors to borrow money from their brokerage firm to purchase securities. The securities bought serve as collateral for the loan, and the investor pays interest rates on the borrowed amount. While margin accounts offer the potential for magnified returns through leverage, they also introduce significant risks, including the possibility of a margin call and the loss of more than the initial investment. Confusion often arises because both types of accounts can hold securities, but only a margin account enables borrowing to facilitate purchases.

FAQs

What is a margin call?

A margin call is a demand from your brokerage firm to deposit additional funds or securities into your margin account. This occurs when the equity value in your account falls below a certain percentage of the total value of your investments, known as the maintenance margin. If you fail to meet a margin call, the firm can sell your securities to cover the shortfall.

Can I lose more money than I invested in a margin account?

Yes, it is possible to lose more money than your initial investment in a margin account. Because you are using leverage by borrowing funds, if the value of the securities you purchased declines significantly, the losses can exceed the amount of your own capital. You are still obligated to repay the full margin loan.

Are there different types of margin requirements?

Yes, there are typically two main types: initial margin and maintenance margin. Initial margin is the percentage of the purchase price you must pay with your own funds when first buying a security on margin. Maintenance margin is the minimum equity you must maintain in your account after the purchase. Both are set by regulators and brokerage firm policies.

What happens if I don't meet a margin call?

If you don't meet a margin call by depositing the required funds or securities, your brokerage firm has the right to sell assets in your account to cover the margin deficiency. This can happen without prior notice and may result in selling your investments at a loss, potentially even forcing you to sell securities you had not intended to. This is a form of liquidation.