Investing on Margin
An Introduction to Investing on Margin
Turbo charge your returns, but be careful of the added risk
Margin is a term used in the financial markets to describe the practice of only paying an initial amount for the purchase of a financial product and the balance is never paid.
Numerous financial products can be bought on margin, such as stocks, mutual funds, Exchange Traded Funds (ETFs), commodities such as oil or gold, and currencies to name a few. The focus of this article will be on purchasing stocks on margin.
When an investor buys a stock on margin, they only ever pay the deposit which for a standard brokerage account is a minimum of 50%. The deposit is referred to as either a margin deposit or the initial margin. The balance is paid from a loan that is made by the investor's broker and financed by the broker's bank. The loan (which is known as a margin loan) is secured with the stock as collateral. Interest is charged on the loan balance at the prevailing interest rates, which tends to be amongst the cheapest of loans available (due to the ease of liquidating stocks, thus reducing the risk to the lender).
The maximum an investor can borrow with a margin loan is set by the Federal Reserve Bank (the Fed) with a regulation known as a Regulation-T, which restricts ordinary investors from borrowing more than 50% of the stocks purchase value. This is intended by the Fed to limit the amount of risk that an investor can take on.
Buying on margin of 50% will effectively double the amount of stock that can be purchased with the cash they have in their account. The investor will therefore receive twice the amount of dividends paid, but will have to pay interest on the 50% that was borrowed to settle the stock purchase. Any capital gains made are doubled, but any losses made are also doubled. Therefore it is not a free lunch and here is where the risk lies with buying stocks on margin.
If a portfolio of stocks bought on 50% margin goes up in value, everything is fine and investor really as a nice double boost to their capital gain. The problem is if the value of this margined portfolio of stocks actually goes down (and it's a big problem!).
The portfolio value is calculated daily by the broker from the closing stock prices. If stock prices fall and the portfolio value drops below a threshold level, the investor is faced with what is known as a margin call.
A margin call simply means that the broker no longer considers the investor's portfolio to be sufficient collateral for the money the broker lent the investor.
If the broker imposes a margin call, the investor has three options.
Receiving a Margin call:
- The investor can sell sufficient shares to reduce the loan balance. The money received from the stock sold is used to pay down the loan balance.
- The investor can deposit sufficient cash into their brokerage account to make up for the lost value in the stocks. The portfolio value is actually the sum of the stocks value and the cash balance.
- The investor can do nothing and the broker will sell sufficient shares to reduce the loan balance. The money received from the stock sold is used to pay down the loan balance.
When an investor receives a margin call, they do not have any time to waste. Typically, if the margin call is not resolved by the investor the next day, the broker will sell down the investor's stocks.
While margin calls are not pleasant, they do
help investors to preserve their capital
While an investor can theoretically buy stock up to the maximum limit, it is a sure fired way of triggering a margin call as there is no allowance for market volatility. Professional and experienced investors keep a comfortable level of safety that allows for the market's fluctuations.
Buying on margin has its advantages and disadvantages. While the upside potential is fantastic, the stock investor needs to determine for themselves if they can emotionally handle the disadvantages, since the value of a portfolio tumbles far more quickly when on margin and to make things worse, the investor has to pay loan interest on top of their losses.
The possibility of a margin call is always there and it's a part of investing with borrowed money. Basically, the closer to the maximum limit the investor gets, then the higher the likelihood that they will be faced with a margin call. If the prospect of a margin call would cause the investor some concern or distress, then it would probably be better if the investor avoided buying stocks on margin.
How Stock Margin Works
Be aware that there are two regulatory authorities that govern margining requirements
There are two types of margin accounts that stock investors can use. The first is the standard margin account that most stock investors use and is known as a "Regulation-T margin account". The second account type is known as a Portfolio margin account and is generally restricted to professional and experienced investors and requires a minimum account value of US$100,000.
The focus of this article is on Regulation-T margin accounts, which will simply be referred to as a margin account.
The Feds Regulation-T restricts brokers to lending no more than 50% of a stocks purchase value. Brokers will typically loan the maximum permitted, but they are under no obligation to do so and some brokers will not loan the maximum.
Stocks bought with margin accounts are settled with cash if there is sufficient cash in the investors account to pay for the stock purchase. Margin loans are only used once there is insufficient cash to settle the purchase and any existing stocks held are also used as collateral for the loan (not just the current stock being purchased).
Example: An investor has $3,000 cash in their account, they can buy a maximum of $6,000 of stock with a broker that allows the maximum Regulation-T loan limit of 50%. However, if the investor chose to only buy $4,000 worth of stock, the full $3,000 in cash is used as the deposit and the margin loan is only 1,000 or 25%.
This is because cash is used first and a loan is only used when there is insufficient cash to settle the purchase. If the investor had only bought $2,000 then the stock would be settled with $2,000 in cash and no loan used as there was sufficient cash.
The Feds Regulation-T (which determines the maximum that can be loaned for each stock purchase) is only applicable at the time of purchase. After the order to buy is filled, another organization known as Financial Industry Regulatory Authority (FINRA) takes over for the ongoing monitoring of the margin account to ensure there is sufficient collateral value in the investor's portfolio.
FINRA Rule 4210 states that an investor's equity (portfolio value less loan amount) must be greater than or equal to 25% of the current portfolio's value. This is known as a maintenance margin and 25% is the minimum limit that FINRA allows brokers to use. Brokers may use higher values than the 25% minimum and they even use 50% for the maintenance margin.
When the equity of an investor's portfolio drops below the maintenance margin percentage set by the broker, then the broker will issue the investor with a margin call.
For example, an investor has a portfolio that is currently worth $10,000 with a margin loan balance of $4,000 and a broker maintenance margin requirement of 50%. The maintenance margin is $5,000 (50% of $10,000) and the equity is $6,000 ($10,000 less $4,000). A margin call is not issued since the equity is greater than the maintenance margin.
FINRA Rule 4210 also states that the minimum account balance required to purchase stocks on margin is $2,000. If the account balance is less than $2,000, then only cash can be used to settle the purchases.
The investor needs to be aware that there are stocks which are restricted and cannot be bought on margin. Generally stocks that are less than $2 cannot be margined.
Some brokers will calculate the portfolio value at the end of the day while others will continuously calculate the portfolio value throughout the trading day.
The stock investor needs to carefully check their broker's margin requirements as these vary between brokers and some brokers may have different requirements depending on the investor's experience level.
Specifically, the investor needs to be clear on the initial margin and maintenance margin requirements, what the stock price limits are for margining and whether the portfolio value is calculated at the of the day or throughout the day.
The Margin Lending Process
A step by step guide
Stock investors who are not familiar with the margin leading process, may find the whole concept of margin investing somewhat confusing!
There are actually two different regulatory authorities - the Federal Reserve Bank (the Fed) and the Financial Industry Regulatory Authority (FINRA).
These two authorities look after different aspects of margin lending:
Margin Lending - Regulatory Authorities:
- The Feds Regulation-T applies only to the loan for the stock's initial purchase, not to a margin loan on an existing portfolio of stocks. This loan is used at settlement to pay up to 50% of the purchase price.
- FINRA Rule 4210 applies to the margin requirements of the portfolio. These are the stocks the investor already owns and these stocks can also be used as collateral for a margin loan. Thus, if the investor has sufficient equity in their portfolio, they can use their portfolio of stocks as security to borrow additional funds under FINRA Rule 4210.
If the investor has no cash in their account, but does have sufficient equity in their portfolio, then that equity can be used as collateral for a margin loan under FINRA Rule 4210. These funds can then be used as a margin deposit for a stock purchase, with the remaining finances coming from the Regulation-T margin loan of up to 50%. Thus in this case the purchase is made with two different loans.
Even though the Regulation-T loan and the portfolio equity loan are initially really two different sources of funding, the day after the stock purchase the Regulation-T is no longer applicable and thus merely becomes part of the portfolio's loan as one single loan and not two. It's just that initially they were sourced from two different avenues. In other words, the day after the stock's purchase, the Regulation-T loan becomes part of the portfolio loan which is governed by the maintenance margin requirements of FINRA Rule 4210.
When a stock investor purchases stock, any cash available in the account is used first to settle the purchase. Margin loans are only used when there is insufficient cash. Stocks that were originally settled with cash can later be used as collateral for a margin loan and these funds can then be used for margin deposits.
These margin concepts are best clarified with the aid of illustrated examples.
The following nine examples assume a Regulation-T margin account with the full 50% loan limit, a FINRA Rule 4210 maintenance margin requirement of 25% and the portfolio is valued at the close of each trading day.
The initial account balance will be $10,000 in cash with no stocks in the portfolio. It should be stressed that the following examples are illustrative only.
The stock investor purchases $6,000 worth of stock. Since this amount is available in cash from the account, the stock will be settled with cash only. The stock investor now has $4,000 in cash and stocks worth $6,000. The portfolio value is still $10,000 assuming no changes in market prices.
|Start of day||End of day|
The stock investor purchases an additional $6,000 worth of stock. Since the stock investor has $4,000 in cash remaining from the previous days purchases, there is insufficient cash to pay for the full purchase cost. Regulation-T will allow a maximum loan of 50% which is $3,000, but only $2,000 needs to be borrowed to settle this purchase.
|Start of day||End of day|
The stock investor now has a margin loan of $2,000 which was sourced from the Regulation-T loan. The next day this $2,000 loan will be subject to FINRA margin requirements and will no longer be part of the Regulation-T requirements.
The stock investor purchases a further $6,000 worth of stock. Since the stock investor has no cash remaining, the broker will borrow $3,000 form the equity in the investor's portfolio and use this for the margin deposit at settlement. Regulation-T allows a maximum loan of 50% which is $3,000 and this will be used along with the $3,000 from the margin equity loan to settle this purchase. Thus the full $6,000 was effectively sourced from two loans, even though they are shown as one loan.
|Start of day||End of day|
The FINRA maintenance margin check is now required and it includes the current days purchases since these are now part of the portfolio.
- The maintenance margin requirement is $4,500 (25% x 18,000). As the Equity of $10,000 is greater than the $4,500 maintenance margin, no FINRA margin call is issued.
However, there is also a Regulation-T margin call that needs to be checked (since a stock was purchased on the day) and is determined as follows.
- If the equity at the end of the stock purchase day is less than the sum of the Regulation-T loan amount and the existing maintenance margin requirement (which excludes the day's purchases) then a Regulation-T margin call is issued.
- $3,000 (Regulation-T loan) + $3,000 (maintenance margin) = $6000
This satisfies Regulation-T since the equity of $10,000 is greater than the $6,000 Regulation-T margin required.
The stock investor decides to purchase $20,000 worth of stock and places the order with their broker. The broker always performs a check to see if the proposed stock purchase would lead to a margin violation. If the proposed stock purchase would trigger a margin call, then the broker will reject the order.
|Start of day||End of day|
The above Table shows the proposed order of $20,000 and its effect on the portfolio.
- The FINRA maintenance margin requirement is $9,500 (25% x 38,000). As the Equity of $10,000 is greater than the $9,500 maintenance margin, no FINRA margin call would be issued.
Checking for a Regulation-T margin call gives;
- $10,000 (regulation-T loan) + $4,500 (maintenance margin) = $14,500
As the equity of $10,000 is less than the $14,500 Regulation-T margin required, the broker will reject the order to purchase $20,000 worth of stock as it would trigger a Regulation-T margin call.
The stock investor now decides to see if an order to purchase $10,000 of stock would be accepted.
|Start of day||End of day|
The above Table shows the proposed order of $10,000 and its effect on the portfolio.
- The FINRA maintenance margin requirement is $7,000 (25% x 28,000). As the Equity of $10,000 is greater than the $7,000 maintenance margin, no FINRA margin call would be issued.
Checking for a Regulation-T margin call gives;
- $5,000 (regulation-T loan) + $4,500 (maintenance margin) = $9,500
As the equity of $10,000 is greater than the $9,500 Regulation-T margin required, the broker will accept the order to purchase $10,000 worth of stock.
So far the stocks prices have been kept constant, whereas in reality they move up and down from day to day. Let's assume market prices have increased the portfolio's value by $4,000.
|Start of day||End of day|
The FINRA maintenance margin is now $8,000 (25% x $32,000) which is actually $1,000 more than day 5, however the equity has increased by $4,000. Thus, as market prices increase, the stock investor's equity increases more quickly than what the maintenance margin requirement increases. The equity loan remains the same as no additional loans have be made and no funds have been deposited to reduce the loan balance.
The investor could buy more stocks on margin if so desired and the procedure is the same as for day 5.
The stock investor decides to deposit an additional $5,000 into the account. The effect on the account is that the loan balance is reduced to $13,000 and the equity is increased to $19,000. Note that when depositing cash, it reduces down the loan balance.
|Start of day||End of day|
There is no change to the maintenance margin requirement as this is calculated from the value of the stocks. Depositing additional cash has no effect on the stocks value, but does reduce the loan amount that was used to pay for their purchase.
The next thing stock investors need to deal with is what happens if market prices drop significantly to a level that would trigger a FINRA margin call. Let's assume that market prices halved.
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The above Table shows the affect on the portfolio is if market prices halved.
- The FINRA maintenance margin requirement is $4,000 (25% x 16,000). As the Equity of $3,000 is now less than the $4,000 maintenance margin required, a FINRA margin call is issued.
The majority of margin calls issued by brokers are for violation of the FINRA maintenance margin requirements. This occurs whenever the investor's equity falls below the maintenance margin required.
Regulation-T violations are possible, but tend to be very rare as brokers pre-check all purchase orders prior to accepting them. A Regulation-T margin call would generally only occur if the market prices dropped significantly by the time the market closed and the investor was heavily margined with little or no surplus equity (Equity less maintenance margin).
The more surplus equity an investor has, then the lower the probability of being issued a margin call. The lower the surplus equity, the higher the risks are with buying stocks on margin.
Having received a margin call on day 8. the stock investor now needs to determine whether to deposit more money or sell some stock. Both scenarios are considered below.
|Start of day||End of day Deposit money||End of day Sell stock|
If the stock investor deposits $1,000, this will reduce the loan balance by $1,000 and hence increase the equity to $4,000, thus satisfying the FINRA maintenance margin requirement. Of course if market prices fall again the next day, then the investor will be faced with another margin call. Thus, the stock investor will need to deposit more funds than merely the minimum.
Should the investor decide to sell stocks, then $4,000 worth will need to be sold. This will reduce the loan to $8,000 and leave $4,000 in equity, thus satisfying the FINRA maintenance margin requirement. Of course if market prices fall again the next day, then the stock investor will be faced with another margin call. Selling stocks on a margin call is not desirable as the investor is selling under unfavorable conditions (a forced sale).
The best solution is to (as far as possible) avoid a margin call in the first place. When investing on margin, the stock investor needs to be more vigilant with their portfolio monitoring and take appropriate action before market conditions escalate to the point where a margin call is imminent.
Most professional and experienced stock investors maintain a reasonable equity surplus which gives them more leeway if stock prices decline. Investors who push their margin portfolios to the maximum are at a high risk of receiving a margin call.
Portfolio Margin Accounts
For serious investors
There are two types of margin accounts that stock investors can use. The first is the standard margin account that most stock investors use and is known as a "Regulation-T margin account" as discussed in the article the margin leading process. With this account type, the initial loan to settle the stock purchase is governed by the Federal Reserve Banks Regulation-T and the ongoing margin requirements are governed by Financial Industry Regulatory Authority FINRA Rule 4210.
The second account type is known as a "Portfolio margin account" and is the focus of this article.
Portfolio margin is not regulated by the Feds Regulation-T or FINRA and this can allow stock investors to buy stocks on margin with lower initial and maintenance margin requirements. The rules governing portfolio margin are self regulated by the broker under U.S. Securities and Exchange Commission (SEC) approved rules.
With a portfolio margin account, the broker calculates the risk profile of all the stocks held in a portfolio to ascertain what level of margin to apply to the portfolio.
Unlike Reg-T accounts, Portfolio margin accounts calculate
the individual risk for each stock in the portfolio
Unlike the Regulation-T margin account which has a fixed percentage for the initial and maintenance margin requirements, the portfolio margin account has variable initial and maintenance margin requirements which are determined by the balance and proportion of the stocks held in the portfolio.
Balance refers to the number of stocks and their position value. Essentially the more balanced the portfolio is, the lower the margin requirements will be. A portfolio with 20 stocks of similar position value and risk will have a lower margin requirement than a portfolio of only 2 stocks. A portfolio with 20 stocks which includes a couple of stocks with very large position values will have a higher margin requirement than a portfolio with 20 stocks of similar position value.
The risk profile of an investor's portfolio of stocks is accessed by the broker using a risk based pricing model that calculates the largest potential loss of all positions held. The volatility of each stock in the portfolio is compared to the markets volatility. Portfolios that have position sizes which are substantially and disproportionately larger than other positions in the portfolio, will have an adverse effect on the risk profile. The risk profile that provides the worst case lose is used to determine the margin requirements.
The portfolio margin approach determines the risk of loss of each stock rather than simply using a fixed percentage for all stocks as the Regulation-T and FINRA rules use.
The minimum margin requirement is generally 15% for both the initial and maintenance margin.
Portfolio margin accounts provide increased leverage for balanced portfolios, but are generally not suitable for accounts that hold large proportions of only a few stocks as the margin requirements tend to be higher than the FINRA margin of 25%.
The portfolio margin account requires a minimum account value of US$100,000 and therefore restricts this account type to larger portfolios. For investors with portfolios over US$100,000, a portfolio margin account has the benefit of providing some extra cushioning in terms of receiving a margin call due to the lower maintenance margin requirements for a balanced portfolio.
Stock investors who favor portfolio margin over the Regulation-T margin accounts tend to be active investors would are continually buying and selling stocks to adjust their portfolio. Since they are actively monitoring their portfolio, the lower margin requirements allow them to amplify their gains without any unnecessary risks from the higher leverage.
The portfolio margin account does need to be monitored more closely than a Regulation-T margin account. If the portfolio value drops below $100,000, brokers may enforce the FINRA maintenance margining requirements which may trigger a margin call due to the generally higher FINRA margin requirement of 25%.
For experienced investors with account balances well over US$100,000, the portfolio margin account gives them another option to consider.