Margin is the use of borrowed funds in brokerage accounts to buy securities using the securities as collateral. Like any loan, the borrower must pay interest while the loan is outstanding and eventually pay the loan back.
In the early years of stock exchanges, there were no legal minimum margin requirements. Indeed, during the 1920s, margin requirements were 10% or even less, leading to a highly inflated stock market that eventually crashed in 1929. Many people and businesses were wiped out because they were unable to pay for their stock, causing the bankruptcies of many others. This contagion spread throughout the economy, precipitating the Great Depression. Although many new financial regulations were passed in the 1930s, it was not until 1945 that the United States Federal Reserve instituted minimum margin requirements. Later, stock exchanges and even brokerages also set their own minimum requirements, although their requirements cannot be lower than the Federal Reserve requirement, since the Federal Reserve has national authority to regulate margin requirements.
Interest on borrowed funds — margin interest — is slightly higher than the prime rate that banks charge to their best customers. To use margin, the customer must open a margin account with a broker, and the money is borrowed from the broker. The interest rate charged by the broker will depend on how much the broker pays its bank for the money — called the brokers rate — plus whatever amount the broker decides to add. Typically, brokers have a sliding scale of margin interest that depends on the size of the individual trading account, with larger accounts paying lower interest rates than smaller accounts.
Margin can also refer to the minimum equity required to insure the performance of an obligation. A common example is the margin needed to short stocks. To sell a stock short, you borrow the shares from a broker, then sell them in the market, with the hope of being able to buy the shares back at a lower price. The proceeds of the stock sale are placed in your brokerage account. Although you are not buying the stocks initially, you will still be required to have a minimum equity in your account before you can short the stock to guarantee that you will be able to repurchase them later, even if the stock price exceeds the shorted price. You do not have to pay interest nor do you earn any interest on the sale proceeds, because the money is not yours, but is held as security to repurchase the stock later.
Like the margin requirement to short stocks, the term margin is also used in futures and forex accounts that specify the amount of cash or cash equivalents, such as U.S. Treasuries, required to guarantee the performance of the futures or currency contract. In futures, the margin requirement is called a performance bond, because it is not borrowed money, but a deposit that guarantees the performance of the contract until settlement. A trader pays no interest on the margin in a futures or forex account — in fact, traders can earn interest by depositing U.S. Treasuries in a futures account to cover the margin requirement.
In futures and forex, the margin requirement is often expressed as a leverage ratio, which is inversely related to the margin percentage:
|Leverage Ratio |
Example: Calculating the Margin Percentage from the Leverage Ratio
A 50:1 leverage ratio yields a margin percentage of 100/50 = 2%. A 2:1 ratio yields 100/2 = 50%, which the Federal Reserve establishes as an initial minimum for buying or shorting stocks. Forex brokers often advertise a 50:1 ratio, allowing you to buy $100,000 worth of currency while posting a mere $2,000! Forex brokers can offer these low margin requirements because currency doesn't move with the same magnitude as stocks, especially in a short time, but the large leverage ratio does make currency trading very risky if only a 2% margin is used.
Leverage Ratio = 1/Margin Percentage = 100/Margin Percentage
Example: Calculating the Leverage Ratio from the Margin Percentage
Most stockbrokers require at least a 50% initial margin, therefore:
Leverage Ratio = 1 / 0.5 = 2
In other words, you can buy twice as many stocks using maximum margin than you can without using margin. Your investment is leveraged for greater profits or greater losses.
Margin ratios are much smaller in futures than for stocks, where leverage ratios are typically 10:1, which equals a 10% initial margin requirement, but this varies depending on the underlying asset, and whether the trader is a hedger or a speculator — speculators have a slightly higher margin requirement. Forex accounts have an even lower margin requirement, which varies, depending on the broker. Regular forex accounts often allow 50:1 ratios, corresponding to a 2% margin requirement. Forex brokers historically had margin requirements as low as 0.5%, corresponding to a 200:1 leverage ratio, but the National Futures Association increased the minimum margin to 2%, a 50:1 leverage ratio. Forex margin requirements may also depend on the currency being traded, with more frequently traded or stable currencies having the lowest margin requirements.
The rest of this article will discuss using margin for buying or shorting stocks. More information about using margin in futures and for forex can be found here:
- Futures and Options on Futures — an Illustrated Tutorial
- How to Calculate Leverage, Margin, and Pip Values in Forex, with Examples
Margin Agreement, Initial Margin, Maintenance Margin, Margin Calls, and Restricted Accounts
The most general definition of margin, one that covers both buying and shorting securities, is the ratio of the equity of the account divided by the value of the securities. The equity of the account is simply what is left when the debit balance is paid in full or the shorted stocks have been repurchased and returned to the lender.
Borrowed money must be repaid, so the amount borrowed plus the accrued margin interest is a debit to the account; if stocks are sold short, then the shorted stocks must be repurchased, so the value of the shorted stocks are a debit to the account.
|Value of Securities|
To use margin for trading, you have to open a margin account by signing a margin agreement. The agreement stipulates, among other things, the initial margin requirement as a percentage, and the margin maintenance percentage. Any securities bought in a margin account are held in the broker's street name, and the margin agreement usually gives the broker the right to lend the securities out for a short sale.
Margin trading is governed by the Federal Reserve, and other self-regulatory organizations (SROs), such as the New York Stock Exchange and the FINRA. Regulation T, promulgated by the Federal Reserve, requires that the minimum deposit be $2,000, and that the initial margin percentage be at least 50%.
There is also a minimum maintenance margin requirement of 25%. The exchanges or the brokerages can set stricter requirements than those required by the Federal Reserve if they choose. At most brokerages, the maintenance margin requirement is set higher, usually at 30%.
The margin ratio cannot be less than the maintenance margin rate. If the margin ratio falls below 50%, but remains above the maintenance margin requirement, then the account will be restricted. No additional securities can be bought or sold short in a restricted account, unless the trader deposits additional cash or securities to increase the margin level to at least 50%.
The available margin will depend on the price of the securities. If margin is used to buy securities, then the amount of margin increases with the market value of the securities, but the amount of margin for shorted securities is inversely related to the price of the shorted securities, decreasing as security prices increase, and vice versa.
If the equity does drop below the maintenance margin requirement, then the broker will issue a margin call, requesting that additional cash or securities be deposited so that the margin ratio of the account equals at least 50%. If you do not timely provide enough equity to satisfy the margin call, your broker will sell enough securities purchased on margin and/or repurchase your shorted securities at the market to bring your margin ratio back to the initial margin requirement.
The main reason to borrow money to buy securities is for financial leverage. Financial leverage can increase the rate of return for an investment, if it is profitable, but it also increases potential losses. Because of the potential for greater losses, traders become more emotional in their trading decisions, which may cause excessive trading, which increases transaction costs, and it may cause bad trades when emotion overrules reason. Furthermore, the longer the money is borrowed, the greater the amount of margin interest that must be paid, so using margin for buy-and-hold strategies is generally not a good idea.
Another major disadvantage to using margin is that the trader potentially loses some control over the account. If purchased stock drops too much, the broker has the right to sell the stock before notifying the customer. For a short sale, the broker may be forced to repurchase the securities in an illiquid market, if the lender wants the securities back.
If the margin ratio increases because purchased securities have increased in value or because shorted securities have decreased in value, then the trader gains excess margin that can be used to purchase or short additional securities. Continually using excess margin to increase investments is called pyramiding. While pyramiding may work for a while, at some point, the equity of the account will decline, because stocks don't continually increase in value nor do shorted stocks continually decline in value. Therefore, eventually there will be a margin call. Hence, the use of margin should be restricted to short-term trades.
In a long transaction, you borrow money to buy securities, which you are obligated to repay. Similarly, in a short sale, you sell securities short by borrowing the securities from a broker, then selling them, with the proceeds deposited in your account. But eventually you'll have to buy the securities back to return them to the lending broker, which is why the market value of the shorted securities is considered a debit to your account.
Equity equals the total value of cash and securities if all open positions are closed and all financial obligations are satisfied. So if you deposit $5,000 in an account, and borrow $5,000 to buy $10,000 worth of stock, then your equity is initially $5,000 minus transaction costs. Accruing margin interest will also decrease your equity. If the value of the stock declines to $8,000, then your equity is reduced to $3,000 minus costs, because now the stock is worth $8,000, but you are still obligated to pay your broker $5,000 plus interest for the loan, which is your debit balance. Hence, when using margin to borrow money to enter into a long position by buying stocks:
Equity = Account Value – Debit Balance
|Value of Securities|
When margin is used to short securities, then equity equals the amount on deposit minus the value of the shorted securities.
So if you sold short $10,000 worth of stock instead of buying stock with your deposit, then your equity will equal the $15,000 on deposit ($5,000 deposit + $10,000 from short sale) minus the value of the shorted security, which is initially the $10,000 that you sold it for. If the value of the stock rises to $12,000, then your equity is reduced by $2,000, because you're obligated to buy the stock back, so if you closed your position right now, you would pay $12,000 to buy the stock back and have $3,000 left in your account (minus transaction costs and dividend payouts). Since shorted securities must be repurchased, the debit balance = the current market value of the shorted securities.
Equity = Account Value – Value of Shorted Securities
Note that the account value will be decreased by transaction costs and by any dividends paid while the stock is borrowed.
Example: Calculating the Equity of a Short Account
If you deposit $5,000 and sell 1,000 shares of XYZ stock short for $10 per share, then there is $15,000 on deposit in your account, but your equity is still $15,000 - $10,000 = $5,000, which is, of course, what you initially deposited.
- If XYZ price rises to $12 per share, then your equity = $15,000 - $12,000 = $3,000.
- If XYZ price drops to $8 per share, then your equity = $15,000 - $8,000 = $7,000.
|Value of Shorted Securities|
So the only difference between calculating the margin for a purchase and for a short sale is that the equity for a purchase is the account value minus the debit balance whereas for a short sale, the equity is the account value minus the value of the shorted securities. Both the debit balance and the value of the shorted securities are obligations you eventually must pay.
Example: Calculating the Current Margin and Current Equity of a Short Sale.
You open a margin account and deposit $5,000. You sell short 1,000 shares XYZ stock for $10 per share. The proceeds of the sale, $10,000, is deposited in your account for a total account value of $15,000.
Scenario 1 — The stock price declines to $6 per share, so the 1,000 shares that you sold short is currently worth $6,000. Thus:
- your equity = $15,000 - $6,000 = $9,000
- your margin = $9,000/$6,000 = 1.5 = 150%
Thus, this short sale would be profitable if you repurchased the shares now to cover your short, for a net profit of $4,000 minus brokerage commissions and any dividends paid to the lender of the stock while the stock was borrowed.
Scenario 2 — The stock price rises to $12.00 per share, so it will cost you $12,000 to repurchase the shares now.
- your equity = $15,000 - $12,000 = $3,000
- your margin = $3,000/$12,000 = .25 = 25%
Because your current margin is now less than 30%, you will be subjected to a margin call. If you decide to repurchase the shares now to cover your short, your net loss will be $2,000 plus brokerage commissions and any dividends paid while the stock was borrowed.
Remember that the above formulas and calculations have been simplified by excluding transaction costs, margin interest, and any dividends that had to be paid for shorted stock. These excluded factors reduce the equity in your account.
Calculating Margin Call Account Values
The margin maintenance requirement requires that the margin ratio always be equal to or greater than the margin maintenance requirement. If the margin ratio drops below this, then a margin call will be issued, requiring you to provide enough equity to bring the margin back up to the initial margin requirement, usually 50%. At what account value will a margin call be issued?
First, we consider the use of margin for buying securities. We can derive this formula from the formula for calculating the margin.
- Margin = (Account Value - Debit) / Account Value
- Let m = margin ratio; a = account value; d = debit
- m = (a - d) / a
- m × a = a - d Multiply both sides by a.
- m × a - a = -d Subtract a from both sides.
- a - a × m = d Multiply both sides by -1.
- a (1 - m) = d Factor out a from the left side.
- a = d / (1 - m) Divide both sides by (1 - m).
- Account Value = Debit / (1 - Margin)
Example - Finding the Account Value That Will Elicit a Margin Call
You deposit $5,000 and borrow $5,000 to buy $10,000 worth of securities. If the maintenance margin requirement is 30%, what is the value of the securities that will cause a margin call to be issued?
- Account Value = Debit / (1 - Margin)
- Account Value = $5,000 / (1 - .30) = $5,000 / .7 = $7,142.86
Hence, a margin call will be issued if the value of the securities drops below $7,142.86. To verify the answer, we'll plug this account value into the margin formula to see if it comes out to the maintenance margin percentage:
Margin = ($7,142.86 - $5,000) / $7,142.86 = $2,142.86 / $7,142.86 = 0.30 = 30%
Now we determine the formula for calculating the value of securities that will elicit a margin call for shorted stock, which is a slightly different equation:
- Margin = (Account Value - Value of Shorted Securities) / Value of Shorted Securities
- Let m = margin ratio; a = account value; and v = value of shorted securities.
- m = (a - v) / v
- m * v = a - v Multiply both sides by v.
- v + m * v = a Add v to both sides.
- v (1 + m) = a Factor out v from the left side.
- v = a / (1 + m) Divide both sides by 1 + m.
- Value of Shorted Securities = Account Value / (1 + Margin)
Example: Calculating the Margin Call Price of a Shorted Security
You open a margin account and deposit $5,000. You sell short 1,000 shares XYZ stock for $10 per share. The proceeds of the sale, $10,000, is deposited in your account for a total account value of $15,000. The margin maintenance requirement is 30%. Therefore, the margin call value = 15,000/(1 + .3) = 15,000/1.3 = $11,538.46, equal to a price per share of $11,538/1,000 = $11.54 (rounded) per share. So a margin call will be triggered when the price of the shorted security rises to $11.54.
To verify, we substitute $11,538.46 into the margin formula for shorted stock, and find that (15,000 - 11,538.46)/11,538.46 = 0.30 = 30%, the margin maintenance requirement. Note that if any dividends were paid out, this would have to be subtracted from the account value.
Return on Investment
Margin increases the rate of return on investment, if the investment is profitable, but increases losses, if not. Furthermore, transaction costs, margin interest, and any dividend payments for shorted stock subtract from profits but add to losses. Dividends received from purchased stock will increase profits and reduce losses. For a purchase, the rate of return is determined by the following equation:
|( Stock Sale Price |
+ Dividends Received
– Stock Purchase Price
– Margin Interest )
|Long Rate of Return||=|
|Stock Purchase Price|
For instance, if you purchased $10,000 worth of stock with cash and the stock rises to $12,000, then your return on investment is:
Rate of Return = ($12,000 + 0 - $10,000 - 0 ) / $10,000 = $2,000 / $10,000 = 20%
If instead of paying cash for the stock, you pay $5,000 cash and use $5,000 of margin, then your rate of return, ignoring margin interest to simplify things:
Rate of Return = $2,000 / $5,000 = 40%
As you can see, using the maximum amount of margin almost doubles your rate of return if the holding period is short enough to keep margin interest negligible. From this example, you can also clearly see that if the stock value decreased by $2,000 instead of rising, then there would be minus signs in front of the rates of return. Furthermore, margin interest increases potential losses and subtracts from potential profits. To illustrate, if your broker charges 6% annual margin interest and you hold the stock for 1 year, then your broker will charge $300 of interest for the $5,000 you borrowed for 1 year. Thus, the rate of return if stock is sold for $12,000 is:
Rate of Return = ($12,000 - $10,000 - $300) / $5,000 = $1,700 / $5,000 = 34%
If the stock is sold at a loss for $8,000:
Rate of Return = ($8,000 - $10,000 - $300) / $5,000 = -$2,300 / $5,000 = -46%.
The longer the margin is borrowed, the more margin interest will decrease any potential profits and increase potential losses.
Note that the equation for shorted stock would be slightly different, since, as a short seller, you must pay any dividends to the lender of the stock that the lender would have otherwise received, but you do not have to pay margin interest. However, you do have to post enough equity to satisfy the initial margin requirement, typically equal to ½ of the value of the shorted stock. Thus, the equation for the rate of return for the short seller is:
|( Stock Sale Price |
– Dividends Paid
– Stock Purchase Price )
|Short Rate of Return||=|
|Initial Margin Requirement|
Day-Trading Margin Requirements
Because of the risks of day trading, FINRA has established a much higher equity requirement of $25,000, as cash or securities, for day trading accounts, though brokers can require higher amounts. This minimum margin requirement applies to what FINRA defines as a pattern day trader, a trader who trades more than 4 times within 5 business days and the day trading activities constitute more than 6% of the total trading activity within the same period.
The minimum equity must be in the account the day before any day trades and maintained at all times. Only the equity in the account is the measure of whether the equity satisfies the statutory minimum. Funds in any other accounts, even with the same broker, cannot be used to cross guarantee the minimum equity requirement. So any funds in a savings or checking account at the same broker cannot be used to satisfy the minimum equity requirements. If the minimum equity falls below $25,000, then day trading will not be permitted until the minimum is restored. Any funds used to satisfy the minimum equity requirement must remain in the day trader's account for 2 business days after the day when the deposit was required.
The day trading margin requirement is based on the day trader's largest open position during the day rather than the open positions at the end of the day, since day traders, by definition, close all of their positions before the end of the day.
A pattern day trader can trade up to 4 times the equity in excess of the maintenance margin requirement as of the close of the previous business day; otherwise, a margin call will be issued, requiring the trader to meet the margin call within 5 business days; meanwhile, day trading will be restricted to 2 times the maintenance margin excess, including trades already outstanding. If the day trading margin call is not satisfied by the 5th business day, then the account will be further restricted to cash only trades for 90 days or until the margin call is satisfied.
The brokerage may designate a trader as a pattern day trader if it is reasonable in doing so. Once a trader is defined as such, then the brokerage firm will code the account accordingly, and that designation will persist, even if the trader stops day trading, until the trader contacts the brokerage firm to get the designation removed and also ceases to be a pattern day trader.
These day trading margin requirements became effective on September 28, 2001 and applies to all day traded securities, including options, even if no leverage is used.
Free riding is also prohibited, where the trader sells the security before paying for it. The broker is required to place a 90-day freeze on the account if the trader violates this prohibition.
A Major Risk Using Margin: Margin Calls May Force a Stock Sale at the Market Bottom
Using margin is risky. Sometimes stock prices drop so fast, there is no time for margin calls, so the broker is forced to sell margined stock at low prices, potentially devaluing an account to zero or even less! A good example was provided by the Great Recession of 2008. During the week ending October 13, 2008, the average stock price plunged 18%, forcing many investors who bought stock on margin to sell, which was probably a major factor contributing to the steep decline. Consider these examples reported in this New York Times article, Margin Calls Prompt Sales, and Drive Shares Even Lower:
- Aubrey K. McClendon, chief executive of Chesapeake Energy, was forced to sell his entire stake of 33.5 million shares in his company at a price range of $15 - $22 per share. In July, the stock price was above $60 per share.
- Sumner M. Redstone, the chairman of Viacom and CBS, was forced to sell $400 million worth of shares in his companies to pay down debt.
- One senior wealth management executive reported that people with $30,000,000 in their brokerage accounts were wiped out in days.
A primary risk of using margin is forcing you to sell at the very time when stock prices hit bottom! And since other investors will also be forced to sell in the declining market, the market declines even further. When the stock market starts declining, it is best to sell some stock to lock in gains and to pay off margin; otherwise you will be forced to sell low after you bought high, which is the simple formula for losing money!
Stocks in Margin Accounts Can Lead to Empty Voting and Payment in Lieu of Dividends
There are 2 disadvantages to holding stocks in a margin account, which are often lent out to short sellers:
stock borrowers, but not stockholders, can vote shares when the shares are lent out, which leads to what is being called empty voting;
and if the stocks pay a dividend, the stockholders actually get — instead of a dividend that may qualify for the favorable tax rate of 0%, 15%, or 20% — a payment in lieu of dividends, which is taxed as ordinary income that may be as high as 37%. See Taxation of Dividends for more information.
Worse, the borrowers of the stock, often short-sellers, can vote against the corporation's interest to put downward pressure on the stock price, so as to increase short-selling profits — thus, voting against the interests of the true stock owners.
A possible scenario is for a hedge fund, which frequently profits from short selling, to borrow the shares right before the record date — usually 30 days before the vote, and vote in its own interests. Delaware law, which governs most large companies because they are incorporated in that state, gives voting rights to whomever happens to have the stock on the record date. Often, the beneficial owners of the stock are unaware of the lending, and that their right to vote has been transferred to someone else.
Sometimes, because of inadequate accounting, both actual stockholders and the borrowers vote, leading to overvoting, which the New York Stock Exchange had found to be a frequent occurrence in some instances.