When investors open a margin account with a brokerage, they gain the ability to buy stocks using a combination of borrowed funds and their own capital. This practice of trading on margin is made possible by the brokerage firm extending a line of credit that allows leveraged investing.
However, margin trading doesn’t come without risks. To limit the downside, regulatory bodies, and brokerages have instituted initial margin and maintenance margin requirements. Understanding these two core concepts is crucial for anyone considering opening a margin account.
This comprehensive guide examines the key differences between initial margin versus maintenance margin, how both work and the implications for trading on margin.
What is Initial Margin?
The initial margin refers to the percentage of the purchase price that you must pay in cash upfront when buying securities on margin. It represents the minimum equity you must contribute from your own capital.
For stock trades, Regulation T issued by the Federal Reserve Board requires U.S. brokerages to set the initial margin at no less than 50% of the total amount.
For example, if you purchase $10,000 worth of stock on margin, at least $5,000 must come from your account balance. The brokerage can loan you the other $5,000, which creates the leveraged position.
Some key facts about initial margin:
- Applies to new purchases made using margin loans
- Set by Regulation T at 50% minimum for most securities
- Brokerages can set higher “house” requirements if desired
- Determines the maximum leverage you can utilize
- Must be funded using your own capital
The initial margin gives brokerages a buffer against risk since you are putting up a substantial equity amount. Higher initial margin requirements equal less leverage.
What is Maintenance Margin?
The maintenance margin represents the minimum equity you need to keep in your margin account at all times after making a leveraged purchase.
For stock trades, Regulation T dictates that brokers must set the maintenance margin at no less than 25% of the current market value of the securities.
For example, if you purchase $10,000 of stock on 50% initial margin and the value drops to $8,000, your equity would need to be at least 25% of $8,000, or $2,000.
Key facts about maintenance margin:
- Applies after the initial purchase as a minimum equity requirement
- Set by Regulation T at 25% minimum of current market value
- Brokerages often set higher “house” maintenance requirements
- Falling below the level triggers a margin call
- Can be met by depositing more cash or selling securities
The maintenance margin gives brokerages a way to mitigate losses on margin loans by requiring you to maintain adequate equity. If the account value declines, you may need to add more cash or collateral.
Comparing Initial Margin vs Maintenance Margin
While initial margin and maintenance margin both deal with required equity levels in a margin account, some key differences determine how they impact leveraged trading:
- Initial margin sets the maximum leverage when entering a position
- Maintenance margin aims to limit losses after establishing the position
- Initial margin applies at time of purchase
- Maintenance margin applies continually after purchase
- Initial margin is higher at 50% minimum
- Maintenance margin is lower at 25% minimum
- Initial margin controls degree of leverage
- Maintenance margin prevents overleveraging
- Initial margin remains fixed at time of trade
- Maintenance margin fluctuates based on market value
- Falling below initial margin prevents opening position
- Falling below maintenance margin triggers margin call
These contrasts show that the initial margin requirement is more significant in determining how much leverage can be used. The maintenance margin acts as a protective floor to force the addition of equity as market values change.
How Much Leverage Can You Obtain?
The maximum leverage available to you depends entirely on the initial margin requirement since it dictates what percentage of the purchase price must come from your capital versus borrowed funds.
For example, let’s say you want to buy $100,000 of stock and the initial margin is 50%. You would need to contribute $50,000 in equity and could borrow the other $50,000 from the brokerage. This would give you 2:1 leverage since you are buying 2x the amount your cash deposit would normally control.
Now consider an initial margin set at 30%. To purchase $100,000 of stock, you would only need to contribute $30,000 of equity this time. The brokerage loans you $70,000, giving you 3.33:1 leverage.
A lower initial margin requirement equals higher leverage. However, regulators and brokerages try to strike a balance between allowing leverage and curtailing risky overleveraging.
Why You’ll Rarely Reach the Maintenance Margin Limit
While the 25% minimum maintenance margin allowance seems high, in practice you will rarely actually reach that level of leverage. Here is why:
The initial margin sets the maximum leverage when first establishing the position. To get to the maintenance margin limit, the value of your holdings would have to decline substantially without you adding any additional equity along the way.
For example, if you purchase $100,000 of stocks on 50% initial margin, you contribute $50,000 and borrow $50,000. For the equity to drop to 25% of the value, the holdings would need to fall to around $66,667, representing a $33,333 loss.
Most traders using margin will cut losses before reaching that point by depositing more cash or closing out positions. Brokerages also routinely issue margin calls as equity falls, demanding additional equity well before the minimum 25% level.
So while the maintenance margin technically permits more leverage, the initial margin requirement serves as the practical limit in most cases when first establishing a leveraged position.
Alternatives For Higher Leverage
For traders seeking leverage beyond what traditional margin accounts offer, a few alternatives exist:
Exchange-traded funds that use debt and derivatives to multiply returns on an underlying index. Common leverage factors are 2x and 3x.
Derivatives that allow taking large positions with less capital using substantial leverage. Margin requirements can be 5% or less of the total contract value.
Buying call options controls large equity amounts with smaller cash outlays. Options can achieve 5:1 or greater implicit leverage based on the premium cost.
Margin accounts for forex currency trading permit leverage up to 50:1 in the U.S. and higher in other countries. High risks due to excessive leverage.
Carefully evaluate whether the high leverage provided by these alternatives suits your risk tolerance and portfolio goals. The amplified potential rewards can be attractive, but the compounded risks make it easy to get in over your head.
Examples of Margin Requirements in Action
Let’s walk through some examples to demonstrate how initial and maintenance margin requirements work in practice:
- You deposit $10,000 cash in new margin account
- You purchase $20,000 of Stock XYZ with 50% initial margin
- Your equity is $10,000 and you borrow $10,000 from brokerage
- XYZ drops to $18,000 total value
- Your equity is still $10,000 which exceeds 25% maintenance margin
In this case, no action is required since equity stays above the maintenance margin minimum.
- You deposit $10,000 cash in margin account
- You purchase $20,000 of Stock XYZ with 50% initial margin
- Your equity is $10,000 and you borrow $10,000
- XYZ drops to $16,000 total value
- Your equity is $6,000, below 25% maintenance margin
- You receive margin call to deposit additional equity
Here the margin call was triggered because the equity fell below the minimum requirement.
- You deposit $25,000 cash in margin account
- You purchase $50,000 of Stock XYZ with 50% initial margin
- Your equity is $25,000 and you borrow $25,000
- XYZ rises to $75,000 total value
- Your equity is now $50,000, exceeding the 25% maintenance margin
This example shows how the leverage decreases as the asset value rises above the purchase price.
Key Takeaways on Margin Requirements
- The initial margin sets the maximum leverage when first buying stocks on margin.
- A maintenance margin is a minimum equity level that must be maintained at all times.
- Initial margin requirements are generally higher, making them more binding.
- Alternatives like leveraged ETFs can provide higher leverage.
- Falling below the maintenance margin triggers a margin call by the brokerage.
- Monitor equity daily and be prepared to add cash to avoid margin calls.
Margin trading allows greater leverage, but also greater risk. Understanding the initial margin vs maintenance margin requirements is key to avoiding costly mistakes.
The initial margin establishes the maximum leverage that can be utilized when first entering a position. The maintenance margin sets an ongoing minimum equity level. While the maintenance margin technically permits more borrowing, the initial margin serves as the binding constraint in most cases.
Always evaluate your risk tolerance and portfolio goals before trading on margin. Employ stop orders and diversification to reduce concentration risk. Monitor equity daily and maintain an adequate buffer above minimums. Margin can provide strategic leverage when used prudently, but also leads to magnified losses if used imprudently.
Frequently Asked Questions
Q: Can a brokerage change their initial or maintenance margin requirements?
Yes, brokerages can adjust their margin requirements at any time based on market conditions and risk management needs. In particular, some increase requirements during periods of high volatility. The only restriction is they cannot set initial margin lower than 50% or maintenance margin lower than 25%.
Q: Does a market sell-off trigger automatic margin calls?
Not necessarily. Margin requirements factor in the current market value of securities. So as stock prices decline substantially, minimum equity dollar amounts required by maintenance margins will decrease automatically in tandem. Investors do not necessarily get a margin called if equity as a percentage of holdings stays constant.
Q: Can you ever borrow more than 50% when trading stocks on margin?
Technically yes, once your equity exceeds maintenance margin requirements. For example, if you have 40% equity and meet a 30% maintenance margin, you could borrow additional funds while staying above the 30% floor. But the maximum leverage is still capped at the time of the initial purchase based on initial margin rules.
Q: What happens if you don’t meet a margin call?
Suppose you do not deposit additional equity by the deadline in a margin call. In that case, the brokerage has the right to liquidate any positions necessary in your account to bring it into compliance. So it is essential to promptly take action when you receive a call, either by adding cash or selling securities yourself.
Q: Do day trading rules apply to margin accounts?
Yes, day trading margin requirements apply. Under FINRA rules, if you make four or more day trades within five business days, your account will be designated a pattern day trader. This requires maintaining a minimum equity of $25,000 in a margin account on any day trades are made.
Q: Can you get a margin loan for a non-marginable security?
No, Regulation T margin requirements only allow borrowing against securities that are classified as marginal by the brokerage or regulator. However, some brokerages offer other types of securities-backed loans or lines of credit that permit borrowing against non-marginable assets.
Q: How is the maintenance margin calculated on a short sale position?
For short sales, the maintenance margin is calculated based on the value of the cash proceeds received when the short position was opened, not the market value of the shares borrowed. This effectively creates an incentive to close out short positions as the market price declines.
In another related article, House Maintenance Requirements for Margin Accounts: A Comprehensive Guide
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