If you want to start trading on an exchange, you should be aware of margin requirements. They differ from one platform to another but are obligatory for any investor. In this guide, you will discover the difference between minimum and maintenance margin requirements using practical examples and will find out how they work.
What is Margin Requirement
Margin requirements are the obligations for an investor to make a minimum deposit into an account in order to make trades. Margin requirements are introduced to discourage investors from accumulating debt.
The exact amount of margin requirements are not similar for all platforms and countries. Usually, the account must have a specified percentage of the planned transactions. Currently, in most stock markets, an investor can make a trade if he has at least half of the required amount in his margin account.
Moreover, if the deal turns out to be profitable and starts to generate a profit, the margin account can be used again. And if the deal was not profitable, all the funds go towards repayment, the investor uses the rest of the funds in the same way when making transactions on credit.
In futures trading, the situation is a bit different: the amount of margin requirements is determined depending on the final amount of the transaction and its type. Thus, a successful investor can conduct transactions using margin and is insured against losing a large amount of funds.
So, for long positions, you could have at least a quarter of the necessary funds on your account, and for short positions - a third. This practice allows you to avoid a situation called ‘margin call’, which occurs if the prices of the acquired assets fall or rise beyond the positions agreed with the broker.
Who Sets Margin Requirements?
Although legislative systems differ from one region to another, all countries with large exchanges adhere to the strategy of margin requirements. In addition, each exchange has the right to establish its own regulatory system, which its participants will have to adhere to. The basis for creating standards is often taken from the position of the New York Stock Exchange, it was one of the first to set margin requirements for investors.
The Federal Reserve’s Regulation T also defines the rules for margin requirements. It applies to both initial margin at the moment of stock purchase, and maintenance margin requirements, which is the minimum sum that should stay on the user’s account to keep deals open.
Advantages of margin requirements
Benefits for the investor:
- The investor gets the opportunity to make trading operations for amounts significantly exceeding his capital. As a result, there is a rapid growth in the volume of transactions and in case of successful trading, profits are higher.
- The investor does not need to have the amount necessary for the transaction with him or provide it in any other way, except by depositing margin. This benefit is especially noticeable in capital-intensive markets.
- From a technical point of view, the investor can benefit even if prices fall, since in any case the transaction amount will exceed the funds available to him.
Benefits for the broker:
- The broker receives additional funds as interest on long-term (more than one day) loans. Typically, the interest rate on a margin loan exceeds the rate on deposit. Therefore, brokers rarely invest in a bank deposit and often use capital to profit from lending to investors.
- For each transaction, the broker receives a commission, which depends on the volume of the transaction. The principle of margin trading is simple: the client makes transactions for a larger amount than he has, respectively, the broker’s remuneration is higher.
- There is an opportunity to attract new clients due to the fact that the minimum threshold for participation in trading is quite acceptable for many potential investors who want to explore stock trading, but do not want to deposit large sums.
Margin Drawbacks
Trading with leverage has some disadvantages that you should be aware of.
It implies a higher risk
For margin trading, you have to borrow money and pay back the loan without delays, whether you gained or lost money. Meanwhile, there’s no guarantee that your deal will finish successfully.
While leverage multiplies your earnings it can also multiply your losses if your asset price predictions appear to be wrong. Hence, you could end up losing more money than was added to your portfolio.
Say, you purchase a stock worth $2,000. You use $1,000 of your own funds and $1,000 of margin. If the stock loses 75% of its value, you will only get $500 after selling it.
You will use the remaining $500 to repay half of your margin loan and deposit $500 more to cover your debt.
You will have to pay interest
No broker would lend you money for free. In most cases, borrowing comes with an interest based on the amount you’ve borrowed (or it can be a fixed rate depending on the broker’s requirements).
Thus, when you are planning how much to invest, always consider the cost of borrowing. Any interest reduces gains of successful deals and adds up losses from failing investments.
When you open positions with small sums, the interest rate could leave you without profit even in case of a successful deal.
Maintenance Requirements
Leverage trading positions come with two margin requirements: one for creating a deal and another for keeping it open. If you don’t have enough funds, either you won’t be able to open a deal, or it will be automatically closed.
Once you open a position by purchasing shares, your portfolio will have to maintain a certain minimum deposit to meet the
What Are Margin Account requirements?
As we’ve mentioned, margin requirements are the minimum that every investor should have in their account. At the same time, it is not forbidden to deposit an amount that fully secures the transaction or have more funds than necessary. Compliance with margin calls protects not only the investor from large losses and accumulation of debt but also the broker, who is confident that the rewards will be paid in full.
The amount of margin requirements is directly correlated with the liquidity of the goods for which it is planned to make a deal. So, on currency exchanges, the margin is rarely higher than 2%.
It is a common practice to charge a fee if a loan is required for a period of more than one day. Typically, the percentage is agreed upon in advance and is calculated depending either on the amount of money or on the current market value of the assets. Also, the interest rate varies depending on the type of assets but still correlates with the average rate of the Central Bank established in the country.
Minimum Margin
The minimum margin is the amount that must be present on the account in order to complete trading operations. It is introduced to protect clients from the risks posed by large deals and the formation of serious debts.
What is the Initial Margin Requirement?
When it comes to US exchanges and brokerage platforms, the initial margin should be at least 50% of the deal. Say, an investor plans to purchase 1,000 shares at $5 each, then the total price would be $5,000. A margin account with a brokerage firm allows investors to purchase 1,000 shares for as low as $2,500 - the brokerage service will cover the rest $2,500. Hence, shares of the stock serve as collateral for the loan, and investors pay interest on the borrowed volume.
Some brokerage firms require higher upfront payments. For example, if a firm required 65% of the purchase price, the loan would be up to $1,750 meaning the investor would have to pay $3,250.
How Does Initial Margin Requirement Work? - Example
Now, imagine that the cost of the stock has increased to $10 per share. Then, the investor decides to sell all 1,000 shares for $10,000. He will need to pay $1,750 for the loan, leaving $8,250 after the initial investment of $3,250. Even after returning the interest on a loan, the investor wins from the margin.
However, if the price of stock drops, the investor would have to pay the interest in addition to facing losses on the investment.
What is the Maintenance Margin Requirement?
Maintenance margin is the volume of funds that should be left on an investor’s account to keep a position and prevent a margin call. This capital is utilized when the price moves in the opposite direction - otherwise, the deal would be closed with the trader losing the staked funds.
How Does Maintenance Margin Requirement Work? - Example
Every exchange comes with requirements to minimal balance. To maintain open deals, there must be a certain amount of funds on the account. As a rule, the calculation is made depending on the current market rate in the basic currency (USD or EUR in most cases) or the last transaction settlement.
If the account balance is below the minimum, all open positions will close automatically. Sometimes, the profile may be blocked until the user replenishes it. Also, the minimum margin depends on the size of leverage and market quotes. In recent times, exchanges started raising the minimum margin because of high price fluctuations.
In many platforms, the maintenance margin is 30%. Say, you have $20,000 worth of stocks and $10,000 was borrowed as leverage. If the total value of your holdings goes below $14,000, while the amount of your debt is $10,000, it means your equity is worth less than $4,000, which is below 30%. Then your deal may be closed.
What is a margin call?
Initially, the term ‘Margin call’ was used to refer to a situation when a broker sends a notification to a client that additional funds must be deposited into the account in order to maintain open positions, otherwise the transaction will be closed. This was relevant for those times when transactions were mainly made by phone. Nowadays, margin calls may be sent via email or mobile notifications.
If a Margin Call is not attended, transactions may be forced to close by a broker when a certain minimum margin limit is exceeded. In some cases, deals are closed automatically because the broker does not have the opportunity to send a notification to the client about the approaching Margin Call, and the client cannot replenish the account so quickly.
When the amount of funds in your trading account decreases and does not cover the margin required to ensure current operations, the broker requests you to replenish the deposit. This requirement is called a margin call. Its execution allows you to increase the amount of funds in the account to the level necessary for covering the margin.
How to Avoid a Margin Call?
Thanks to margin requirements, traders can use leverage safely. However, if the price of shares goes in the opposite direction, a trader will face a margin call and potential closure of deals. Here’s how you can prevent losing your funds:
- Always have spare cash in your account. Instead of investing every single dollar, you should set aside some part of your deposit to avoid margin calls. With this cash cushion, you could remain active even if the price of stocks fluctuates.
- Protect yourself against volatility. The best thing you can do is diversify your portfolio by holding different kinds of securities. The list of your investments can include stocks, derivatives, commodities and so on. Thanks to that, you could preserve your funds against unpredictable market conditions.
- Make regular payments. Investors receive interest charges every month. Since there is no certain repayment schedule for loans, the investor can plan to earn from both deals and interest charges. That will also help you cover your loans and keep the balance under control.
- Set your own maintenance margin. Ideally, it should be higher than the bare minimum. When your margin account balance goes off the limit, you should top up your account to increase the balance. With this strategy, you will be able to avoid margin calls and have more free funds for high-potential securities.
Conclusion
Margin requirement is an essential part of any trading activity. For brokers, it ensures that traders will be able to pay their debt back. The latter, in their turn, can take leverage and maximize their profits in case of successful deals. Still, remember that leverage raises not only potential profits but also multiplies losses.
The size of margin requirement can differ from one country to another, from one exchange to another. So before you start trading, learn the platform’s terms and conditions. Otherwise, you risk losing your funds or having your account blocked.
