Margins

What Is Margins?

In finance, margins refers to the collateral an investor must deposit with a broker to cover the credit risk the investor poses to the broker. It represents the portion of an investment's value that an investor pays with their own cash, while borrowing the remainder from a broker-dealer. This allows investors to control a larger position in securities than they could with cash alone. The concept of margins is a fundamental aspect of investment finance, particularly in leveraged trading activities.

History and Origin

The practice of buying on margin has a long history in financial markets, predating formalized regulation. Prior to the 20th century, margin requirements were often at the discretion of individual brokers, leading to periods of excessive speculation. The stock market crash of 1929 is frequently cited as a pivotal event that underscored the dangers of unregulated margin lending. Easy access to credit for stock purchases, with very low margin requirements, allowed many investors to take on substantial debt. When the market declined, the ensuing waves of liquidation by brokers to cover losses exacerbated the downturn.

In response to the market instability of the Great Depression, the U.S. government enacted the Securities Exchange Act of 1934, which granted the Federal Reserve Board the authority to regulate the extension of credit in securities transactions. This led to the introduction of Regulation T in 1934, which set initial margin requirements for securities purchases. Since 1974, the initial margin requirement for most equity securities has remained at 50%, meaning investors must pay at least half the purchase price themselves. The Federal Reserve has maintained this percentage despite market volatility, viewing it as a tool to manage systemic risk. Later, other regulatory bodies, such as the Financial Industry Regulatory Authority (FINRA), introduced additional rules like FINRA Rule 4210 to further govern margin accounts and maintenance requirements.¹² Academic research has extensively studied the role of margin requirements in market stability and investor behavior.¹¹

Key Takeaways

• Margins refer to the portion of an investment that an investor pays for with their own funds when borrowing money from a broker to make a purchase.
• Margin accounts allow investors to use leverage, potentially amplifying both gains and losses.
• Initial margin is the percentage of the purchase price an investor must pay upfront, while maintenance margin is the minimum equity percentage that must be maintained in the account.
• Failure to meet maintenance margin requirements can result in a margin call, requiring additional funds or leading to the forced sale of securities.
• Regulation T by the Federal Reserve and FINRA Rule 4210 are key regulations governing margin requirements in the United States.

Formula and Calculation

Two primary margin calculations are crucial for investors: Initial Margin and Maintenance Margin.

Initial Margin
The initial margin is the percentage of the purchase price of a security that an investor must pay in cash. This is typically set by regulatory bodies like the Federal Reserve (under Regulation T) and individual brokerage firms.

Maintenance Margin
The maintenance margin is the minimum amount of equity an investor must maintain in their margin account relative to the current market value of the securities. If the account's equity falls below this level due to market movements, the investor will face a margin call. FINRA Rule 4210 typically sets a minimum maintenance margin of 25% for equity securities.¹⁰ However, many brokerage firms enforce higher "house" requirements, often 30% to 40%.⁹

When the Maintenance Margin Percentage falls below the required threshold, a margin call is triggered.

Interpreting the Margins

Understanding margins involves recognizing that they serve as a form of collateral for borrowed funds. The higher the margin requirement (i.e., the higher the percentage of the investment an investor must pay themselves), the less leverage is being used. Conversely, lower margin requirements enable greater leverage, meaning smaller market movements can have a more significant impact on the investor's percentage returns or losses. For instance, if an investor uses 50% margin, a 10% movement in the stock price effectively translates to a 20% gain or loss on the investor's actual cash invested.

Interpreting margins also involves understanding the distinction between initial and maintenance requirements. The initial margin dictates how much capital is needed to open a leveraged position, while the maintenance margin acts as a ongoing risk threshold. Falling below the maintenance margin indicates that the value of the collateral is no longer sufficient to secure the loan at the pre-determined level, prompting the broker to demand additional funds or sell assets to restore the equity level.

Hypothetical Example

Suppose an investor wants to purchase 100 shares of XYZ stock, currently trading at $100 per share, for a total value of $10,000. Their broker requires an initial margin of 50% and a maintenance margin of 30%.

1. Initial Purchase:

   • Total value of shares: 100 shares * $100/share = $10,000
   • Initial margin required (50%): $10,000 * 0.50 = $5,000
   • Amount borrowed from broker: $10,000 - $5,000 = $5,000
   • The investor contributes $5,000 of their own cash.

2. Market Decline:

   • A few weeks later, the price of XYZ stock drops to $70 per share.
   • New market value of shares: 100 shares * $70/share = $7,000
   • Amount borrowed from broker remains: $5,000
   • Current equity in the account: $7,000 - $5,000 = $2,000

3. Check Maintenance Margin:

   • Maintenance margin percentage: ($2,000 / $7,000) * 100% ≈ 28.57%

Since 28.57% is below the broker's 30% maintenance margin requirement, the investor would receive a margin call. To meet the call and avoid forced liquidation, they would need to deposit additional funds or sell some of their securities to bring their equity back above the 30% threshold.

Practical Applications

Margins are integral to various aspects of modern financial markets, enabling investors to engage in more complex investment strategy and increasing market liquidity.

• Securities Trading: The most common application is in standard equity trading, where investors use margin to buy more stocks than they could with their available cash. This is governed by regulations such as the Federal Reserve Board's Regulation T and FINRA Rule 4210., ⁸T⁷hese rules mandate how much credit broker-dealers can extend to customers for the purchase of securities, setting initial and maintenance margin requirements. T⁶he U.S. Securities and Exchange Commission (SEC) also provides investor bulletins to educate the public on the risks and mechanics of using margin accounts.
  *⁵ Futures and Derivatives Trading: Margins are fundamental in futures, options, and other derivatives markets. In these markets, margins do not represent a down payment on an asset's purchase but rather a performance bond or good faith deposit to cover potential losses. Due to the high leverage inherent in these financial instruments, margin requirements are often adjusted dynamically based on market volatility.
• Short Selling: When an investor short sells a security, they borrow shares and sell them, hoping to buy them back later at a lower price. Margins are required to cover the potential risk if the price of the borrowed security rises, as the investor would need to buy it back at a higher cost.
• Portfolio Margining: For sophisticated investors with diverse portfolio holdings, some brokers offer portfolio margining. This system calculates margin requirements based on the overall risk of the entire portfolio, rather than on individual positions. This can often result in lower total margin requirements for a diversified portfolio compared to a standard Reg T margin account.

Limitations and Criticisms

While margins offer the potential for magnified returns, they also come with significant limitations and criticisms, primarily centered on increased risk management and the potential for substantial losses.

The most critical limitation of using margins is the amplification of losses. Just as gains are magnified, a downward movement in the market can quickly erase an investor's equity and lead to losses exceeding the initial investment. This inherent leverage means that investors can incur significant debt if trades move against them.

Another major criticism revolves around the margin call. When the value of the securities in a margin account falls below the maintenance margin requirement, the broker issues a margin call, demanding that the investor deposit additional funds or securities. Failure to meet a margin call can result in the forced liquidation of positions by the broker without the investor's consent, often at unfavorable prices, which can lock in substantial losses. The sudden and forced sale of assets can also lead to a domino effect in rapidly declining markets, as seen in historical financial crises where widespread margin calls contributed to market downturns. The Federal Reserve, in a paper on margin requirements, notes that while higher margin requirements may increase the stability of the financial system, they could also reduce market liquidity.

⁴Furthermore, the interest charged on borrowed funds adds to the cost of the investment, which can eat into potential profits, especially during periods of high interest rates or when holding positions for extended periods. Investors must also be aware that brokers can adjust their "house" margin requirements at any time without prior notice, potentially triggering unexpected margin calls.

Margins vs. Leverage

While often used interchangeably in casual conversation, margins and leverage represent distinct but related concepts in finance. Margins specifically refer to the amount of collateral an investor must deposit with a broker when borrowing money to purchase securities or other financial instruments. It is the investor's equity portion of a leveraged trade. For example, if a stock purchase requires 50% margin, it means the investor pays for 50% with their own capital.

Leverage, on the other hand, describes the use of borrowed capital to increase the potential return of an investment. It is the effect or the ratio of using borrowed money. When an investor uses margin, they are employing leverage. If an investor uses 50% margin, they are using 2:1 leverage (meaning for every $1 of their own capital, they control $2 worth of assets). Therefore, margins are the mechanism or the initial deposit that enables leverage, while leverage is the outcome or the amplified exposure gained through that borrowing. One cannot use leverage in a margin account without providing the necessary margin.

FAQs

What is a margin account?

A margin account is a brokerage account that allows an investor to borrow money from their broker to buy securities. The securities purchased act as collateral for the loan. This contrasts with a cash account, where all trades must be fully paid for with available funds.

What is a margin call?

A margin call occurs when the value of the securities in a margin account falls to a point where the investor's equity drops below the required maintenance margin percentage. The broker then demands that the investor deposit additional funds or securities to bring the account back to the required level, or the broker may sell assets in the account to meet the deficiency.

Can I lose more than I invested with margins?

Yes, it is possible to lose more money than your initial investment when trading on margins. This is due to the inherent leverage involved. If the market moves significantly against your position, your losses can exceed the cash you initially deposited, meaning you would owe the broker money.

Are margins regulated?

Yes, margins are regulated by government bodies and self-regulatory organizations. In the United States, the Federal Reserve Board sets initial margin requirements through Regulation T. A³dditionally, the Financial Industry Regulatory Authority (FINRA) establishes maintenance margin rules and other requirements under FINRA Rule 4210. I²ndividual brokerage firms can also set their own "house" margin requirements, which are often stricter than regulatory minimums.

What types of investments can be purchased on margins?

Generally, actively traded stocks, bonds, exchange-traded funds (ETFs), and certain mutual funds are marginable securities. However, some securities, such as penny stocks or certain initial public offerings (IPOs), may not be eligible for purchase on margin due to their higher perceived risk. F¹utures and derivatives also use a margin system, though the mechanics differ slightly from equity margin accounts.