When you provide part of the funds to purchase securities while your brokerage firm provides the rest, this is called buying on margin. Your margin account has a margin maintenance requirement regulated by the Federal Reserve Board and by FINRA (the Financial Industry Regulatory Authority). Buying on margin is generally considered to be a risky investment method best left to experienced investors.
Buying with Margin Maintenance Requirements
The writers for FINRA explain that buying on margin is when you enter into an agreement with a brokerage or securities firm to pay for part of the purchase, while the firm lends you the remainder of the purchase price. This allows investors to make bigger investing moves, but it does come with risks for both the investor and the firm. In order to protect both parties, the Federal Reserve Board and FINRA have issued regulations on how much money the investor has to provide upfront, how much investors can borrow and how much of the investor's own money must remain in the margin account.
Video of the Day
Writers from The Securities and Exchange Commission enumerate the different amounts the investor must provide. Before initiating trading, you must deposit with your firm at least $2,000 or 100 percent of the purchase price, whichever is less. This is called the minimum margin and is set by FINRA Regulation 4210. Once the account is open and funded, you may not borrow more than 50 percent of the purchase price of the security. This is called the initial margin and is set by the Federal Reserve Bureau's Regulation T.
However, many brokerage firms will require that the investor provide more than 50 percent of the purchase price; that is simply the federal minimum. Finally, you must keep a maintenance margin, meaning a certain amount of equity in the margin account. FINRA sets the maintenance margin at 25 percent. If your personal equity in the account falls below 25 percent of the current market value of the purchased security, you may be subject to a margin call from the broker. This means you need to bring your equity in the account back up to 25 percent. Calculating your maintenance margin and understanding how margin calls work is key to trading on margin.
Margin Calls and Calculating Maintenance Margin
Experts from The Corporate Finance Institute explain that the security you purchased on margin must trade above a specific price. Otherwise, your equity in the margin account (the worth of the security relative to how much you borrowed to purchase it) will get too low. If this happens, you'll hit the maintenance margin threshold and be subject to a margin call. The general formula is: Margin Call Price = Initial Purchase Price * (1 - Initial Margin percentage) / (1 - Maintenance Margin percentage).
In the provided maintenance margin example, the initial margin is 50 percent (the federal minimum) and the maintenance margin is 25 percent (the FINRA regulatory minimum). If you purchase a security for $100, borrowing $50 to do so, then the margin call price is $100 * (1 - 50 percent)/(1 - 25 percent) = $100 * 0.50/0.75 = $66.67. That means if the security is trading at $66.67 and you borrowed $50 of that, then your equity is only $16.67. That's 25 percent of the value of the security ($16.67/$66.67), while the firm's lent money makes up 75 percent of the investment ($50/$66.67).
Brokerage Minimums May Vary
Keep in mind that the initial margin and maintenance margin requirements may not be the regulatory minimums. For example, your firm may require a 60 percent initial margin, and you may have purchased a number of shares on margin. In this case, determine the price per share and apply the formula as before.
For example, imagine your broker has set a 60 percent initial margin and a 30 percent maintenance margin. Perhaps you purchased 20 shares on margin for $1,000. The initial purchase price per share is $50, with you contributing $30 (60 percent * $50) per share and the broker contributing $20 (40 percent * $50) per share. The maximum percentage of borrowed funds you're allowed per share is 1 - Maintenance Margin = 1 - 30 percent = 70 percent. Divide the amount you initially contributed per share by this number to get $30/70 percent = $42.86. This is your maintenance margin per share. You bought 20 shares, so you need $857 equity in the account as your maintenance margin. In other words, applying the formula: $1,000 * (1 - 40 percent) / (1 - 30 percent) = $1,000 * 0.60/0.70 = $857. If you have insufficient equity, you can sell securities or add more cash to the account.
Consider also: The Difference Between Contribution Margin and Gross Margin