A customer who purchases securities may pay for the securities in full or may borrow part of the purchase price from their securities firm. If the customer chooses to borrow funds from a firm, the customer must open a margin account with the firm.
The portion of the purchase price that the customer must deposit is called margin and is the customer’s initial equity in the account. The loan from the firm is secured by the securities that are purchased by the customer. A customer may also enter into a short sale through a margin account, which involves the customer borrowing stock from a firm in order to sell it, hoping that the price will decline. Customers generally use margin to leverage their investments and increase their purchasing power. At the same time, customers who trade securities on margin incur the potential for higher losses.
Margin Requirements
The terms under which firms can extend credit for securities transactions are governed by federal regulation and by the rules of FINRA and the securities exchanges. Some securities cannot be purchased on margin, which means they must be paid for in full using available loan value in the margin account, or the customer must deposit 100 percent of the purchase price.
In general, under Federal Reserve Board Regulation T, firms can lend a customer up to 50 percent of the total purchase price of a stock for new, or initial, purchases. Assuming the customer doesn’t already have cash or other equity in the account to cover their share of the purchase price, the customer will likely receive a margin call from the firm. As a result of the margin call, the customer will be required to deposit the other 50 percent of the purchase price. For example, if the customer purchases $10,000 of stock, the firm loans the customer $5,000 and the customer pays the other $5,000.
FINRA rules supplement the requirements of Regulation T by placing "maintenance" margin requirements on customer accounts. Under these rules, as a general matter, the customer’s equity in the account must not fall below 25 percent of the current market value of the securities in the account. Otherwise, the customer may be required to deposit more funds or securities in order to maintain the equity at the 25 percent level. The failure to do so may cause the firm to force the sale of—or liquidate—the securities in the customer’s account in order to bring the account’s equity back up to the required level.
Margin Transaction—Example
Day 1: You buy $100,000 of margin stocks.
- Regulation T requires you to deposit initial margin of 50 percent, or $50,000, in payment for the securities. As a result, your equity in the margin account is $50,000, and you've received a margin loan of $50,000 from the firm.
Day 2: The market value of the securities loses $40,000, falling to $60,000.
- Under this scenario, your margin loan from the firm would remain at $50,000, and your account equity would fall to $10,000 ($60,000 market value minus $50,000 loan amount). However, the minimum maintenance margin requirement for the account is 25 percent, meaning that your equity must remain above $15,000 (25 percent of the $60,000 market value).
Consequence: Since the required equity is $15,000, your firm will likely issue a maintenance margin call for $5,000 ($15,000 less existing equity of $10,000). If so, and if you fail to meet the margin call by the time and date specified by the firm, the firm could liquidate $20,000 of securities—$5,000 divided by 25 percent in order to meet the maintenance margin call.
Tip: To estimate the potential loss in market value before incurring a maintenance call, use this formula:
Current Maintenance Excess ÷ (1.00 - maintenance requirement percentage)
On Day 1 in the example above, the securities can lose $33,337 in value before incurring a margin call:
$25,000 ÷ (1.00 – 0.25) = $33,337
Firm Practices
Brokerage firms have the right to set their own maintenance margin requirements—often called "house" requirements—as long as they’re more stringent than the margin requirements under FINRA rules. These enhanced requirements can apply broadly or to particular stocks. For example, firms can raise their maintenance margin requirements for specific volatile stocks to ensure there are sufficient funds in their customers' accounts to cover large price swings.
These changes in firm policy often take effect immediately and may result in the issuance of a maintenance margin call. Again, a customer's failure to satisfy the call may cause the firm to liquidate a portion of (or in certain circumstances all of) the customer's account.
Margin Agreements and Disclosures
If you decide to trade stocks in a margin account, carefully review the margin agreement provided by your brokerage firm. A firm charges interest for the money it lends its customers to purchase securities on margin, and you need to understand the additional charges you may incur by opening a margin account.
Your firm is required to provide written disclosure of the terms of the loan, including the rate of interest and the method for computing interest. Your firm must also provide periodic disclosures regarding transactions in your account and the interest charges.
Know Before You Trade
Be aware of the following realities before you trade on margin:
- You can lose more funds than you deposit in the margin account. A decline in the value of securities purchased on margin may require you to provide additional funds to the firm that has made the loan to avoid the forced sale of those securities or other securities in your account.
- The firm can force the sale of securities in your account. If the equity in your account falls below the maintenance margin requirements, under the law—or the firm’s higher "house" requirements—the firm can sell the securities in your account to cover the margin deficiency. You’ll also be responsible for any shortfall in the account after such a sale.
- The firm can sell your securities without notice. Some investors mistakenly believe that a firm must contact them for a margin call to be valid and that the firm cannot liquidate securities in their accounts to meet the call unless the firm has contacted them first. This is not the case. As a matter of customer relations, most firms will attempt to notify their customers of margin calls, but they aren’t required to do so.
- You’re not entitled to an extension of time on a margin call. While an extension of time to meet a margin call might be available to you under certain conditions, you don’t have a right to the extension or even to be notified of a margin deficiency.
- Open short-sale positions could cost you. You may have to continue to pay fees on open short positions even if a stock is halted, delisted or no longer trades.
Margin and Day Trading
A day trade occurs when you buy and sell (or sell and buy) the same security in a margin account on the same day. Specific margin requirements apply to day trading in any security, including options. If you actively trade stocks, learn about day trading.
When Your Firm May Use Your Securities
If your margin account has a debit balance (representing a loan of money from your brokerage firm to you or for your benefit), then your brokerage firm generally is permitted to use securities in your margin account that are worth up to 140% of the debit balance. Among other uses, your brokerage firm can pledge those securities as collateral for a loan, use them to make delivery on short sales by your brokerage firm or other customers, or lend them to third parties who can use them to make deliveries on short sales or for other legal purposes.
Your brokerage firm is required to obtain your permission before lending your securities or commingling your securities with other customer securities as collateral for a loan. (These permissions are generally included as standard terms in your margin account agreement, and your brokerage firm may require you to close your margin account if you revoke them.) Your brokerage firm is also required to separate customer securities pledged as collateral for a loan from any non-customer securities and is prohibited from subjecting customer securities to liens for an amount exceeding the aggregate amount that your brokerage firms’ customers owe to your brokerage firm.
Finally, your brokerage firm must make periodic computations to determine how much money it’s holding that’s either customer money or obtained from the use of customer securities (including amounts borrowed against customer securities and funds raised from loans of customer securities). If this amount exceeds the amount that your brokerage firm is owed by customers or by other broker-dealers relating to customer transactions, your brokerage firm must deposit the excess into a special reserve bank account for the exclusive benefit of customers.
Preventing Your Firm from Using Your Securities
If you don’t want your brokerage firm to use your securities, you can pay off your debit balance or instruct your brokerage firm to transfer securities into your cash account. (If your margin account has a debit balance or a short position, your brokerage firm may require you to pay off that debit balance or deposit other margin before transferring securities to your cash account.) You may also need to terminate any agreement under which your brokerage firm is permitted to borrow fully paid or excess margin securities from you (commonly referred to as a “fully paid lending” agreement or program).