When you’re seeking to increase your buying power as an investor, you may want to use margin, which is basically a loan from your broker. But because trading on margin is risky, you’ll face strict rules, not only from your broker but also from regulatory agencies. Minimum margin is the amount you’ll need to deposit in your account before you start trading on margin.
Want to know more about minimum margin? Learn the basics of how minimum margin works along with the rules you need to follow as an investor.
Definition and Example of Minimum Margin
Margin allows you to use money you borrow from your broker to pursue bigger returns. While margin gives you access to more money to invest, it also exposes you to higher potential for losses. Minimum margin is the amount an investor needs to deposit into their account before they can start trading on margin or shorting stocks. If your margin account falls below the minimum margin, your broker will make a margin call that requires you to add more cash or securities.
FINRA rules require a minimum margin of $2,000 or 100% of the price of margined securities—whichever is less. However, many brokerages set more stringent requirements.
Note
The Federal Reserve Board’s Regulation T also governs the use of margin. Investors can borrow up to 50% of the purchase price of margined securities, which is known as the initial margin.
Once you’ve started using margin, there’s also a maintenance margin, which is the amount you’re required to keep in your account. FINRA sets the maintenance requirement at a minimum of 25% of the total market value of margined securities. However, many brokerages set higher maintenance requirements of 30% to 40% of the securities’ value. Firms often have even higher minimums for high-risk investments.
Suppose you decide to invest $10,000 in a stock using $5,000 of your own money and $5,000 you’ve borrowed from your broker. You’ve met FINRA’s minimum margin rules by depositing more than $2,000. You and your broker are also in compliance with Regulation T because you’re only borrowing 50% of the stock’s purchase price.
But what if the stock’s price drops by 50% when your broker requires a maintenance margin of 40%? You’ll face a margin call, wherein your broker will require you to restore the account’s equity level to 40%—in this case, $4,000.
You’ll face stricter minimum margin requirements if you’re identified as a pattern day trader. Per FINRA’s rules, you’re a pattern day trader if you make four day trades within five business days that exceed 6% of your trading activity for the same five-day period. Pattern day traders must maintain at least $25,000 equity on any day they day-trade. Day trading is prohibited on any day they don’t meet this requirement.
Note
As with any loan, you’ll be charged interest on a margin loan. It’s essential to compare interest rates between brokers before you start using margin, as the interest you pay will reduce your returns.
How Minimum Margin Works
Even if you have the funds to meet the minimum margin, there’s no guarantee you’ll be approved for a margin account. Your broker will consider your annual income, liquid net worth, and possibly your credit history to determine your eligibility.
You can use a number of securities as collateral to meet the minimum margin requirements, including:
- Most securities that trade on the New York Stock Exchange (NYSE) or the Nasdaq
- Most mutual funds that you’ve owned for at least 30 days
- Over-the-counter stocks, if approved by the Federal Reserve Board
- Some bonds issued by corporations, municipalities, or the federal government
Once you’re approved for a margin account and you start trading, your broker is allowed to change its rules, often referred to as “house” requirements, at any time. If the account value dips below the minimum margin threshold, your broker will make a margin call. Typically, brokers give investors two to five days to add more collateral.
But in a volatile stock market, investors may not have the luxury of time. Many brokerages use computer programs to take automatic action if margined securities fall below a certain level. If your account equity falls below the house requirements, your broker can automatically sell investments on your behalf without contacting you.
What It Means for Individual Investors
Even if you have sufficient assets to meet the minimum margin, using a margin account isn’t a good strategy for many investors. While using margin amplifies your potential gains, it also amplifies your losses. It’s possible to lose more money than you invested using margin.
For example, imagine you invested in a stock priced at $100 per share using $50 of your money and $50 of your broker’s, and then the price fell by 50%. With a cash account, you’d only lose 50% of your investment. But if you used margin, you’d be out your entire investment plus interest. You’ve lost $25 of your own money and $25 of your broker’s money. But you still owe your broker $50, on top of interest for the loan.
Before you invest on margin, look beyond the minimum margin requirements. Consider whether you have sufficient liquidity to cover a margin call should the stock’s price crash. If you can’t afford to lose more than you invested, sticking with cash is a wise move.
Key Takeaways
- Minimum margin is the amount of collateral you need in a margin account to trade on margin or shorting stocks.
- FINRA requires a minimum margin of $2,000 or 100% of the price of securities margined, whichever is less. Investors must also maintain at least 25% equity in the account.
- The Federal Reserve Board’s Regulation T allows investors to borrow up to 50% of the margined securities’ purchase price.
- Brokerages are allowed to set their own rules as long as they’re stricter than what regulatory agencies require.
As an avid financial enthusiast and expert in investment strategies, particularly in the realm of margin trading, I can attest to the critical importance of understanding the intricacies involved in leveraging your buying power. My extensive experience in financial markets and comprehensive knowledge of margin trading concepts allows me to shed light on the nuances and potential pitfalls associated with this sophisticated investment strategy.
Let's delve into the concepts mentioned in the article:
Minimum Margin:
Definition and Example: Minimum margin is the collateral an investor needs to deposit into their account before engaging in margin trading or shorting stocks. It acts as a buffer against potential losses. For instance, if you decide to invest $10,000 in a stock using $5,000 of your own money and $5,000 borrowed on margin, you meet FINRA's minimum margin rules by depositing more than $2,000.
Regulatory Requirements: FINRA rules mandate a minimum margin of $2,000 or 100% of the price of margined securities, whichever is less. The Federal Reserve Board’s Regulation T governs the use of margin, allowing investors to borrow up to 50% of the purchase price of margined securities, known as the initial margin.
Maintenance Margin: After initiating margin trading, there's a maintenance margin requirement to ensure ongoing account stability. FINRA sets the minimum maintenance requirement at 25% of the total market value of margined securities. However, brokerages often impose higher maintenance requirements, ranging from 30% to 40%.
Pattern Day Traders: Pattern day traders, as per FINRA rules, must maintain at least $25,000 equity on any day they engage in day trading. Day trading is restricted on days when this equity requirement isn't met.
How Minimum Margin Works:
Eligibility Criteria: Even if an investor has the funds to meet the minimum margin, approval for a margin account isn't guaranteed. Brokers assess factors like annual income, liquid net worth, and sometimes credit history to determine eligibility.
Collateral: Approved securities can be used as collateral to meet minimum margin requirements. This includes most securities traded on NYSE or Nasdaq, mutual funds owned for at least 30 days, approved over-the-counter stocks, and certain bonds.
Changing Rules and Margin Calls: Once approved for a margin account, brokers can change house requirements at any time. If the account falls below the minimum margin, a margin call is issued, giving investors a limited time to add more collateral. In volatile markets, automatic actions may be triggered if margined securities dip below a certain level.
What It Means for Individual Investors:
Risk Amplification: While margin trading amplifies potential gains, it equally magnifies losses. Investors can potentially lose more than their initial investment, especially in a volatile market. A prudent consideration is essential, as illustrated by the example where using margin led to a complete loss of the investment and additional obligations.
Cautionary Approach: Using a margin account isn't suitable for every investor, even if they meet the minimum margin requirements. Adequate liquidity to cover potential margin calls and a realistic assessment of the ability to withstand losses are crucial factors to consider.
In conclusion, a nuanced understanding of minimum margin requirements, regulatory guidelines, and the inherent risks is imperative for anyone considering venturing into the realm of margin trading. It's not merely about meeting the minimums but about a thoughtful and informed approach to risk management in the dynamic landscape of financial markets.
