A step by step guide
Stock investors who are not familiar with the margin leading process, may find the whole concept of margin investing somewhat confusing!
There are actually two different regulatory authorities – the Federal Reserve Bank (the Fed) and the Financial Industry Regulatory Authority (FINRA).
These two authorities look after different aspects of margin lending:
Margin Lending – Regulatory Authorities:
- The Feds Regulation-T applies only to the loan for the stock’s initial purchase, not to a margin loan on an existing portfolio of stocks. This loan is used at settlement to pay up to 50% of the purchase price.
- FINRA Rule 4210 applies to the margin requirements of the portfolio. These are the stocks the investor already owns and these stocks can also be used as collateral for a margin loan. Thus, if the investor has sufficient equity in their portfolio, they can use their portfolio of stocks as security to borrow additional funds under FINRA Rule 4210.
If the investor has no cash in their account, but does have sufficient equity in their portfolio, then that equity can be used as collateral for a margin loan under FINRA Rule 4210. These funds can then be used as a margin deposit for a stock purchase, with the remaining finances coming from the Regulation-T margin loan of up to 50%. Thus in this case the purchase is made with two different loans.
Even though the Regulation-T loan and the portfolio equity loan are initially really two different sources of funding, the day after the stock purchase the Regulation-T is no longer applicable and thus merely becomes part of the portfolio’s loan as one single loan and not two. It’s just that initially they were sourced from two different avenues. In other words, the day after the stock’s purchase, the Regulation-T loan becomes part of the portfolio loan which is governed by the maintenance margin requirements of FINRA Rule 4210.
When a stock investor purchases stock, any cash available in the account is used first to settle the purchase. Margin loans are only used when there is insufficient cash. Stocks that were originally settled with cash can later be used as collateral for a margin loan and these funds can then be used for margin deposits.
These margin concepts are best clarified with the aid of illustrated examples.
The following nine examples assume a Regulation-T margin account with the full 50% loan limit, a FINRA Rule 4210 maintenance margin requirement of 25% and the portfolio is valued at the close of each trading day.
The initial account balance will be $10,000 in cash with no stocks in the portfolio. It should be stressed that the following examples are illustrative only.
Day 1.
The stock investor purchases $6,000 worth of stock. Since this amount is available in cash from the account, the stock will be settled with cash only. The stock investor now has $4,000 in cash and stocks worth $6,000. The portfolio value is still $10,000 assuming no changes in market prices.
Day 1.
| Start of day | End of day | |
| Cash | $10,000 | $4,000 |
| Stocks | $0 | $6,000 |
| Loan | $0 | $0 |
| Portfolio | $10,000 | $10,000 |
Day 2.
The stock investor purchases an additional $6,000 worth of stock. Since the stock investor has $4,000 in cash remaining from the previous days purchases, there is insufficient cash to pay for the full purchase cost. Regulation-T will allow a maximum loan of 50% which is $3,000, but only $2,000 needs to be borrowed to settle this purchase.
Day 2.
| Start of day | End of day | |
| Cash | $4,000 | $0 |
| Stocks | $6,000 | $12,000 |
| Loan | $0 | -$2,000 |
| Portfolio | $10,000 | $10,000 |
The stock investor now has a margin loan of $2,000 which was sourced from the Regulation-T loan. The next day this $2,000 loan will be subject to FINRA margin requirements and will no longer be part of the Regulation-T requirements.
Day 3.
The stock investor purchases a further $6,000 worth of stock. Since the stock investor has no cash remaining, the broker will borrow $3,000 form the equity in the investor’s portfolio and use this for the margin deposit at settlement. Regulation-T allows a maximum loan of 50% which is $3,000 and this will be used along with the $3,000 from the margin equity loan to settle this purchase. Thus the full $6,000 was effectively sourced from two loans, even though they are shown as one loan.
Day 3.
| Start of day | End of day | |
| Cash | $0 | $0 |
| Stocks | $12,000 | $18,000 |
| Portfolio | $12,000 | $18,000 |
| Loan | -$2,000 | -$8,000 |
| Equity | $10,000 | $10,000 |
| Maintenance Margin | $3,000 | $3,000 |
| Reg-T required | $6,000 |
The FINRA maintenance margin check is now required and it includes the current days purchases since these are now part of the portfolio.
- The maintenance margin requirement is $4,500 (25% x 18,000). As the Equity of $10,000 is greater than the $4,500 maintenance margin, no FINRA margin call is issued.
However, there is also a Regulation-T margin call that needs to be checked (since a stock was purchased on the day) and is determined as follows.
- If the equity at the end of the stock purchase day is less than the sum of the Regulation-T loan amount and the existing maintenance margin requirement (which excludes the day’s purchases) then a Regulation-T margin call is issued.
- $3,000 (Regulation-T loan) + $3,000 (maintenance margin) = $6000
This satisfies Regulation-T since the equity of $10,000 is greater than the $6,000 Regulation-T margin required.
Day 4.
The stock investor decides to purchase $20,000 worth of stock and places the order with their broker. The broker always performs a check to see if the proposed stock purchase would lead to a margin violation. If the proposed stock purchase would trigger a margin call, then the broker will reject the order.
Day 4.
| Start of day | End of day | |
| Cash | $0 | $0 |
| Stocks | $18,000 | $38,000 |
| Portfolio | $18,000 | $38,000 |
| Loan | -$8,000 | -$28,000 |
| Equity | $10,000 | $10,000 |
| Maintenance Margin | $4,500 | $9,500 |
| Reg-T required | $14,500 |
The above Table shows the proposed order of $20,000 and its effect on the portfolio.
- The FINRA maintenance margin requirement is $9,500 (25% x 38,000). As the Equity of $10,000 is greater than the $9,500 maintenance margin, no FINRA margin call would be issued.
Checking for a Regulation-T margin call gives;
- $10,000 (regulation-T loan) + $4,500 (maintenance margin) = $14,500
As the equity of $10,000 is less than the $14,500 Regulation-T margin required, the broker will reject the order to purchase $20,000 worth of stock as it would trigger a Regulation-T margin call.
Day 5.
The stock investor now decides to see if an order to purchase $10,000 of stock would be accepted.
Day 5.
| Start of day | End of day | |
| Cash | $0 | $0 |
| Stocks | $18,000 | $28,000 |
| Portfolio | $18,000 | $28,000 |
| Loan | -$8,000 | -$18,000 |
| Equity | $10,000 | $10,000 |
| Maintenance Margin | $4,500 | $7,000 |
| Reg-T required | $9,500 |
The above Table shows the proposed order of $10,000 and its effect on the portfolio.
- The FINRA maintenance margin requirement is $7,000 (25% x 28,000). As the Equity of $10,000 is greater than the $7,000 maintenance margin, no FINRA margin call would be issued.
Checking for a Regulation-T margin call gives;
- $5,000 (regulation-T loan) + $4,500 (maintenance margin) = $9,500
As the equity of $10,000 is greater than the $9,500 Regulation-T margin required, the broker will accept the order to purchase $10,000 worth of stock.
Day 6.
So far the stocks prices have been kept constant, whereas in reality they move up and down from day to day. Let’s assume market prices have increased the portfolio’s value by $4,000.
Day 6.
| Start of day | End of day | |
| Cash | $0 | $0 |
| Stocks | $28,000 | $32,000 |
| Portfolio | $28,000 | $32,000 |
| Loan | -$18,000 | -$18,000 |
| Equity | $10,000 | $14,000 |
| Maintenance Margin | $7,000 | $8,000 |
The FINRA maintenance margin is now $8,000 (25% x $32,000) which is actually $1,000 more than day 5, however the equity has increased by $4,000. Thus, as market prices increase, the stock investor’s equity increases more quickly than what the maintenance margin requirement increases. The equity loan remains the same as no additional loans have be made and no funds have been deposited to reduce the loan balance.
The investor could buy more stocks on margin if so desired and the procedure is the same as for day 5.
Day 7.
The stock investor decides to deposit an additional $5,000 into the account. The effect on the account is that the loan balance is reduced to $13,000 and the equity is increased to $19,000. Note that when depositing cash, it reduces down the loan balance.
Day 7.
| Start of day | End of day | |
| Cash | $0 | $0 |
| Stocks | $32,000 | $32,000 |
| Portfolio | $32,000 | $32,000 |
| Loan | -$18,000 | -$13,000 |
| Equity | $14,000 | $19,000 |
| Maintenance Margin | $8,000 | $8,000 |
There is no change to the maintenance margin requirement as this is calculated from the value of the stocks. Depositing additional cash has no effect on the stocks value, but does reduce the loan amount that was used to pay for their purchase.
Day 8.
The next thing stock investors need to deal with is what happens if market prices drop significantly to a level that would trigger a FINRA margin call. Let’s assume that market prices halved.
Day 8.
| Start of day | End of day | |
| Cash | $0 | $0 |
| Stocks | $32,000 | $16,000 |
| Portfolio | $32,000 | $16,000 |
| Loan | -$13,000 | -$13,000 |
| Equity | $19,000 | $3,000 |
| Maintenance Margin | $8,000 | $4,000 |
The above Table shows the affect on the portfolio is if market prices halved.
- The FINRA maintenance margin requirement is $4,000 (25% x 16,000). As the Equity of $3,000 is now less than the $4,000 maintenance margin required, a FINRA margin call is issued.
The majority of margin calls issued by brokers are for violation of the FINRA maintenance margin requirements. This occurs whenever the investor’s equity falls below the maintenance margin required.
Regulation-T violations are possible, but tend to be very rare as brokers pre-check all purchase orders prior to accepting them. A Regulation-T margin call would generally only occur if the market prices dropped significantly by the time the market closed and the investor was heavily margined with little or no surplus equity (Equity less maintenance margin).
The more surplus equity an investor has, then the lower the probability of being issued a margin call. The lower the surplus equity, the higher the risks are with buying stocks on margin.
Day 9.
Having received a margin call on day 8. the stock investor now needs to determine whether to deposit more money or sell some stock. Both scenarios are considered below.
Day 9.
| Start of day | End of day Deposit money | End of day Sell stock | |
| Cash | $0 | $0 | $0 |
| Stocks | $16,000 | $16,000 | $12,000 |
| Portfolio | $16,000 | $16,000 | $12,000 |
| Loan | -$13,000 | -$12,000 | -$8,000 |
| Equity | $3,000 | $4,000 | $4,000 |
| Maintenance Margin | $4,000 | $4,000 | $4,000 |
If the stock investor deposits $1,000, this will reduce the loan balance by $1,000 and hence increase the equity to $4,000, thus satisfying the FINRA maintenance margin requirement. Of course if market prices fall again the next day, then the investor will be faced with another margin call. Thus, the stock investor will need to deposit more funds than merely the minimum.
Should the investor decide to sell stocks, then $4,000 worth will need to be sold. This will reduce the loan to $8,000 and leave $4,000 in equity, thus satisfying the FINRA maintenance margin requirement. Of course if market prices fall again the next day, then the stock investor will be faced with another margin call. Selling stocks on a margin call is not desirable as the investor is selling under unfavorable conditions (a forced sale).
The best solution is to (as far as possible) avoid a margin call in the first place. When investing on margin, the stock investor needs to be more vigilant with their portfolio monitoring and take appropriate action before market conditions escalate to the point where a margin call is imminent.
Most professional and experienced stock investors maintain a reasonable equity surplus which gives them more leeway if stock prices decline. Investors who push their margin portfolios to the maximum are at a high risk of receiving a margin call.