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Investing on Margin

Terminology

Margin Call

As the stock is used as collateral for the loan, if the stocks price drops below a level that would provide insufficient margin of safety for the loan provider, your stock broker will sell some of your stock in order to reduce the Loan Ratio back to a set maximum level.

Margin Loan

Stocks can be bought using a loan to pay for a percentage of the purchase cost and the investor pays the rest, typically 25% to 50%. This means that the stock investor can effectively buy up to four times as much stock for the same money. The investor pays interest on the loan and stock is used as collateral for the loan.

How Stock Margin Works

Be aware that there are two regulatory authorities that govern margining requirements

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There are two types of margin accounts that stock investors can use. The first is the standard margin account that most stock investors use and is known as a "Regulation-T margin account". The second account type is known as a Portfolio margin account and is generally restricted to professional and experienced investors and requires a minimum account value of US$100,000.

The focus of this article is on Regulation-T margin accounts, which will simply be referred to as a margin account.

The Feds Regulation-T restricts brokers to lending no more than 50% of a stocks purchase value. Brokers will typically loan the maximum permitted, but they are under no obligation to do so and some brokers will not loan the maximum.

Stocks bought with margin accounts are settled with cash if there is sufficient cash in the investors account to pay for the stock purchase. Margin loans are only used once there is insufficient cash to settle the purchase and any existing stocks held are also used as collateral for the loan (not just the current stock being purchased).

Example: An investor has $3,000 cash in their account, they can buy a maximum of $6,000 of stock with a broker that allows the maximum Regulation-T loan limit of 50%. However, if the investor chose to only buy $4,000 worth of stock, the full $3,000 in cash is used as the deposit and the margin loan is only 1,000 or 25%.

This is because cash is used first and a loan is only used when there is insufficient cash to settle the purchase. If the investor had only bought $2,000 then the stock would be settled with $2,000 in cash and no loan used as there was sufficient cash.

The Feds Regulation-T (which determines the maximum that can be loaned for each stock purchase) is only applicable at the time of purchase. After the order to buy is filled, another organization known as Financial Industry Regulatory Authority (FINRA) takes over for the ongoing monitoring of the margin account to ensure there is sufficient collateral value in the investor's portfolio.

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FINRA Rule 4210 states that an investor's equity (portfolio value less loan amount) must be greater than or equal to 25% of the current portfolio's value. This is known as a maintenance margin and 25% is the minimum limit that FINRA allows brokers to use. Brokers may use higher values than the 25% minimum and they even use 50% for the maintenance margin.

When the equity of an investor's portfolio drops below the maintenance margin percentage set by the broker, then the broker will issue the investor with a margin call.

For example, an investor has a portfolio that is currently worth $10,000 with a margin loan balance of $4,000 and a broker maintenance margin requirement of 50%. The maintenance margin is $5,000 (50% of $10,000) and the equity is $6,000 ($10,000 less $4,000). A margin call is not issued since the equity is greater than the maintenance margin.

FINRA Rule 4210 also states that the minimum account balance required to purchase stocks on margin is $2,000. If the account balance is less than $2,000, then only cash can be used to settle the purchases.

The investor needs to be aware that there are stocks which are restricted and cannot be bought on margin. Generally stocks that are less than $2 cannot be margined.

Some brokers will calculate the portfolio value at the end of the day while others will continuously calculate the portfolio value throughout the trading day.

The stock investor needs to carefully check their broker's margin requirements as these vary between brokers and some brokers may have different requirements depending on the investor's experience level.

Specifically, the investor needs to be clear on the initial margin and maintenance margin requirements, what the stock price limits are for margining and whether the portfolio value is calculated at the of the day or throughout the day.

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