What is Margin Trading?
When an investor purchases securities, the securities may be paid in full, or part of the purchase price can be borrowed from a brokerage firm. If funds are borrowed, an investor is trading “on margin.” In order to trade on margin, an investor must open a margin account. The margin account will allow the investor to pay for securities with a combination of cash and borrowed funds. Most investors who open brokerage accounts have cash accounts. More aggressive investors, or investors who want to borrow money to leverage their position, or those who want to sell short, have margin accounts. There are margin requirements for these accounts, set by the Federal Reserve Board. Currently, they are 50% for the initial margin; an investor who wants to use a margin account must deposit cash equal to 50% of the value of the transaction. The remaining cash needed for the purchase of securities is borrowed from the broker. Higher minimums can be set by individual brokerage firms, but they cannot be set lower than what is set by the Federal Reserve Board.
What is The Investor’s Responsibility?
An investor with a margin account must maintain a maintenance margin. This is a minimum percentage of cash equity in the position and is less than the initial margin percentage. If the equity in an investor’s position drops below the maintenance margin percentage, the investor will receive a margin call. A margin call is a request by the broker to add cash to the margin account. If the investor does not add cash in a prompt manner, the broker will liquidate a portion of the investor’s position to cover the margin call. Most brokers will allow two to five days to meet the call. An investor is free to deposit cash into his margin account at any time in order to avoid a margin call.
Investors can calculate the price at which they will receive a margin call on an investment using the following formula:
1- Initial Margin Percentage
1- Maintenance Margin Percentage
Then, multiply this answer by the purchase price of the stock. For example, if a client buys 1,000 shares of a stock on margin with a purchase price of $20, an initial margin of 50%, and a maintenance of 25%, at what price will the investor receive a margin call?
1 – 0.50
1 – 0.25
Dividing these factors will yield .6666. Multiply this answer by the purchase price of the stock ($20), and an investor can expect a margin call at $13.33.
What is the Effect of Risk And Return on Margin Accounts?
Buying securities on margin increases the risk to the investor because the potential loss is greater than it would be if the transaction were a cash purchase. The use of margin increases the investor’s return on the invested funds if the price of the stock rises. However, the potential loss is greater if the price of the stock falls. Some other risks associated with margin trading are:
- More funds can be lost in the margin account that were initially deposited.
- A broker can force the sale of securities in the margin account without contacting the investor.
- Investors cannot choose the securities to be liquidated to meet a margin call.
- Usually, investors are not entitled to a time extension to meet a margin call.
- A firm can increase its maintenance margin requirements at any time without providing the investor with written notice.
The Bottom Line
If investors do not have access to funds that can be used to cover a margin call, they should probably not be trading on margin. Before trading stocks in a margin account, it is important to review and understand the margin agreement, and contact the brokerage firm with any questions or concerns regarding the margin account.
Henssler Financial normally does not recommend trading on margin. However, if funds are needed on a short-term basis, we may utilize margin trading instead of liquidating stocks, and then repurchasing them. For more information regarding this topic, please contact Henssler Financial at 770-429-9166 or [email protected].