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Understanding Initial Margin Requirements

Instructor: Yusuf Abdullah

Yusuf has taught Science and Mathematics at school level and Finance and Economics at University level. He has recently earned his Ph.D in Financial Econometrics.

This lesson deals with margin trading and the initial margin requirements. You'll learn about regulation T, long market value, short market value, debit balance, credit balance, excess equity, buying power of deposited securities, etc.

Margin Trading

James is a freelance financial analyst and has been researching ABC Inc. over the past week. With his research and taking into account the current macroeconomic scenario, he is confident that the stock will rise due to impending government policy measures. James wants to take advantage of this situation to earn some profit. Although he is a great analyst, he does not know much about trading. Therefore, he has approached Joan who is a trader for a large brokerage firm.

James asks about his options to earn more profit. Joan replies that if he is confident, then they can invest over and above the investment value by taking a loan through the brokerage. This investing using debt is known as margin trading. The lender is the brokerage house, and the securities purchased are kept as collateral. James is very excited and wants to invest as much as possible. However, Joan informs him that there are limits to the amount of margin trading.

Regulation T

Joan explains that Regulation T governs the limits to margin trading for long and short market positions. Long market value is the value of securities owned by an investor in a cash account or margin account. Short market value is the value of shares sold short from the cash or margin account.

Regulation T states that the amount of investment from the investor (equity) cannot be less than 50% of the total value of the margin account. This is also referred to as the initial margin. For an already established account, that is already trading, the value of the equity cannot fall below 25%. This level is also known as maintenance margin. If the value falls below 25%, then the investor is required to deposit the funds up to the equity value of 50% or the initial margin. The call for funds is known as margin call.

James now understands the structure of the trading and asks Joan to starts him with a margin account. She tells James that the amount of money lent by the brokerage would be the debit balance, and the amount of money invested by James would be the credit balance or equity in the account. Initially, the debit balance equals the loan value, but changes due to the change in the prices of the securities.

If the value of the securities rise, as James expects them to, the amount of equity in the trading account would increase. This is known as excess equity. James can use excess equity to take out more debt subject to regulations. The buying power is the total value of securities that can be purchased by the investor. Due to Regulation T, the maximum buying power is limited to twice the equity investment made by the investor in the margin account.

Example

James tells Joan that he has $10,000 to invest, and the value of stock ABC is $10 at the moment. Since the value of the stock is expected to rise, James could go long and buy securities. As per Regulation T, 50% must be equity, which is half of the margin account. Hence, the maximum loan that James can get is $10,000.

Long market value = $20,000

Buying power = $20,000

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