The post Key Differences Between Initial Margin vs. Maintenance Margin by Dan Schmidt appeared first on Benzinga. Visit Benzinga to get more great content like this.
Imagine if there was no such thing as a mortgage loan. Instead of borrowing money from the bank to finance your home purchase, you’d have to save up the full amount of the purchase price in order to buy the house — a process that could take decades. Borrowing money can sometimes be the most cost-efficient way to purchase an asset.
Investors also borrow money. If you want to open a stock position but don’t have the necessary capital, you can borrow money from your brokerage firm. When you borrow money from a brokerage firm, the resulting advance is called a margin loan. Trading on margin is riskier than a simple cash investment but could provide a profit boost when utilized properly. In this article, you’ll learn the difference between two types of margin requirements — initial margin vs. maintenance margin.
Trading on margin carries extra risk because your losses could potentially exceed the value of your original investment. For example, if you borrow $10,000 to make a $20,000 investment and the stock you buy drops 60%, your original investment amount is gone and you’d need an extra $2,000 cash infusion to square up with your broker (plus any fees.) Only experienced investors should use leverage and borrowed money.
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What Is Initial Margin?
To borrow money from your brokerage firm, you’ll first need a margin account. Most brokers offer a cash account as their standard vehicle, but margin accounts are required for using strategies like short-selling or trading with borrowed capital. Margin accounts are subject to pattern day trader rules (PDT), and most brokerage firms require a minimum balance of $2,000.
To use borrowed money, you’ll need to request a margin loan for your brokerage account. The money needed to acquire the loan is known as the initial margin, which will be equal to 50% of the total capital required for the initial investment. Note that brokerage firms are not responsible for setting the minimum initial margin level — the 50% figure is set by the Federal Reserve Board through a rule known as Regulation T (Reg T). Reg T sets the minimum; the broker may require more than 50% for certain securities. Additionally, different brokerage firms have different margin rates on their loans to investors. Be sure to check your broker’s margin rates before borrowing capital. Margin trading is not for risk-averse investors.
Formula
To calculate an initial margin figure, you’ll need to find out the margin requirements for the particular investment you want to make. For volatile stocks, the initial margin requirement could be higher than 50%, but 50% is the standard set by Reg T.
The formula goes like this:
Initial Margin = Total purchase price of investment x 0.5 (or more depending on the broker’s requirements)
Minimum Value
The minimum value of initial margin means the lowest amount of capital an investor can put up as collateral for a margin loan. Some brokerage firms may have additional requirements, but Regulation T sets the initial margin minimum value at 50% or a minimum of $2,000.
Example
Suppose you want to invest $100,000 into Apple Inc. (NASDAQ: AAPL) but only have $75,000 in your account. If you have a margin account, you can put up $50,000 as collateral and borrow the remaining $50,000 from your brokerage firm. If Apple appreciates by 10%, your investment will gain 20% since you have $10,000 in profit on a position controlled by $50,000. Of course, if your investment loses money, you could face a margin call from your broker if your account drops below the maintenance margin requirement.
What Is Maintenance Margin?
The maintenance margin differs from the initial margin because it only comes into play after you’ve opened a position with borrowed capital. When using margin trading, you’ll need to put up collateral to open a position and hold a certain amount of cash to maintain that position.
The maintenance margin is the amount of equity you need to maintain in a trade to avoid a margin call, which is set by the Financial Industry Regulatory Authority (FINRA) as a baseline of 25%. But much like the initial margin, maintenance margin requirements may vary from broker to broker and security to security .
Formula
When calculating maintenance margin levels, the formula will look like this:
Maintenance Margin = Total value of investment equity x 0.25 (or more depending on the broker’s requirements)
Minimum Value
The minimum value of the maintenance margin is lower than that of the initial margin. An initial margin is required upfront to acquire a margin loan. But once the margin loan has been issued, the maintenance margin requirement comes into focus. To avoid a margin call, investors must have at least 25% equity in their position at all times. If an investor’s equity drops below this level at any point during the life of the trade, the brokerage firm will issue a margin call and additional funds must be deposited to avoid a forced liquidation.
Investors have two types of margin calls to contend with – federal calls and house calls. The federal call refers to the initial margin requirement, named so because that’s the level set by Reg T. If the initial margin level is broken, the investor will receive a ‘fed call’. A house call comes from the broker and occurs an account drops below the maintenance margin level.
Example
In the trade example above, the investor must produce 50% of the capital required to open the AAPL position based on initial margin requirements. However, once the trade has been executed, the investor only needs to maintain $25,000 in equity to control the $100,000 stock position (25% maintenance margin requirement). If the stock drops 30%, the position will be worth $70,000 but only $20,000 in equity would remain since $50,000 was borrowed from the brokerage firm. In this scenario, the investor will receive a margin call and must deposit more capital.
Always Understand Your Margin Limits and Costs Before Trading with Borrowed Capital
Investors must be keenly aware of both initial and maintenance margin levels when participating in margin trading. Margin requirement minimums are set by regulators, but true margin requirements vary depending on the broker and the invested securities. Additionally, investors must be cognizant of margin rates since borrowing money from a brokerage firm will always come at a cost. Borrowing money can effect an investor’s return, but losses will also be multiplied and forced liquidations will occur if margin calls cannot be met. Always use caution and manage risk when trading on margin.
Frequently Asked Questions
Is the maintenance margin less than the initial margin?
Yes, the maintenance margin requirement is lower than the initial margin requirement. Initial margin is needed to borrow money from the brokerage, but maintenance margin is only needed to avoid a margin call over the duration of the trade.
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Who sets the initial margin?
The minimum initial margin level is set by the Federal Reverse Board through Regulation T at 50%, but brokerage firms can tweak this percentage higher if the securities in question are volatile or hard to borrow or if certain economic events have triggered market uncertainty. Initial margin requirements vary depending on the type of investment the borrowed money is intended for.
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How do you avoid maintenance margin?
To avoid maintenance margin, investors can either use cash accounts and only purchase securities with their available funds or maintain enough equity in their trades to avoid facing a margin call. A margin call can be a negative event if an investor doesn’t have extra capital to deposit and meet the call. If a margin call isn’t met, the broker can choose to liquidate the position without the investor’s discretion or approval. Additionally, when a position is liquidated, the investor is stil responsible for paying back the full amount of the margin loan, plus applicable trading fees or margin rates.
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