Understanding Margin Account Maintenance

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 the maintenance position for margin accounts. You'll earn about initial margin, maintenance margin, margin call, liquidation, withdrawal of equity, etc.

Margin Trading

Professor Moriarty (Prof) is discussing margin trading with his student Irene. He asks if she understands margin trading. She replies that margin trading refers to trading in securities using a loan from the brokerage or a bank. Some of the investment is from the investor and the rest is through the debt. Irene is excited and states that in this way one can earn a large profit if one has an idea about stock movement. Prof tells her to curb her enthusiasm and explains Regulation T of the Federal Reserve. Regulation T mandates that, initially, only half of the total investment can be debt and the rest has to be equity. This is known as the initial margin requirement. Any margin account consists of debt or the loan taken and investor's own contribution i.e. equity.

Maintenance Margin

Prof goes on to explain that margin rules also include maintenance margin. Maintenance margin is the minimum percentage of the value of the equity in the margin account as a result of the loss on the trading position. It is usually set at 25%, but can change when the exchange or the regulator wishes so. When the equity value decreases to less than the maintenance margin, the investor is notified to deposit additional funds. This notification is known as margin call.

Irene understands and states it is only fair that the margin call is made because it is will prevent large losses and protect the lender. She asks how the margin call can be met. Prof informs her that it could be met by either depositing the amount or with an equivalent value of the securities. However, the deposit is to be made to make the value of equity at 50% or initial margin level.

Margin Account Positions

Irene is concerned now and asks what issues can arise if an investor is not able to meet the margin call. Prof replies that there can be serious consequences. The brokerage would sell the securities to recoup the amount lent. This is known as liquidation. Liquidation results in selling at a lower price than the market and results in further trading losses.

Irene wants to focus on the opposite aspect, i.e. when the margin position makes a profit and the value increases. Prof informs her than in such a case, the value of the equity would rise and the percentage of the equity would increase. Now the investor can withdraw money from the account up to the level of the initial margin of 50%. The investor can also withdraw stocks if he/she wishes so. The value of the stocks withdrawn would be taken from the trading value at the time of the withdrawal.

Example

Assume an investor has $5,000 to invest and $20 at the moment. The number of stocks that can be bought is:

$5,000 / $20=250

Loan Value = $5,000 ( debt of $5,000)

Equity = $5,000 ( investor's own money)

Total investment = $10,000

Total stock that can be bought through margin = $10,000 / $20 = 500

To receive the margin call, the value of the equity should go down to 25% from the current 50%.

Margin call is received at 25%. Hence:

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