Initial Margin vs. Maintenance Margin: An Overview
Buying stocks on margin is much like buying them with a loan. An investor borrows funds from a brokerage firm to purchase shares and pays interest on the loan. The stocks themselves are held as collateral by the brokerage firm.
The Federal Reserve's Regulation T sets the rules for margin requirements. There is an initial margin requirement, which represents the margin at the time of the purchase. There is also a maintenance margin requirement, which represents the minimum amount of equity needed in the margin account to keep the position open.
Key Takeaways
- A margin account allows an investor to purchase stocks with a percentage of the price covered by a loan from the brokerage firm.
- The initial margin represents the percentage of the purchase price that must be covered by the investor's own money and is usually at least 50% of the needed funds for U.S. stocks.
- The maintenance margin represents the amount of equity the investor must maintain in the margin account after the purchase has been made to keep the position open.
- The higher initial margin limit is usually more relevant, so leveraged ETFs and call options are typically better for investors who want more leverage.
Initial Margin
The initial margin for stocks at U.S. brokerages must be at least 50 percent, according to Regulation T. Note that forex and commodities traders are allowed to establish positions using much more leverage. If an investor wants to purchase 1,000 shares of a stock valued at $10 per share, for example, the total price would be $10,000. A margin account with a brokerage firm allows investors to acquire the 1,000 shares for as little as $5,000. The brokerage firm covers the remaining $5,000. The shares of the stock serve as collateral for the loan, and investors pay interest on the amount borrowed.
Regulation T requirements are only a minimum, and many brokerage firms require more cash from investors upfront. Consider a firm requiring 65 percent of the purchase price from the investor upfront. That would cover no more than $3,500 with a loan, meaning the investor would need to pay $6,500.
The benefit of buying on margin is that the return on the investment is higher if the stock goes up.
Continuing with the previous example, imagine that the price of the stock doubled to $20 per share. The investor then decides to sell all 1,000 shares for $20,000. The investor will need to repay the brokerage firm the $3,500 for the loan, leaving $16,500 after an initial investment of $6,500. While the stock increased in value by 100 percent, the investor's $6,500 increased in value by more than 150 percent. Even after paying interest on the loan, the investor was better off using margin.
There is also more potential downside when using margin. If the price of the stock drops, the investor will be paying interest to the brokerage firm in addition to making larger losses on the investment.
Maintenance Margin
Once the stock has been purchased, the maintenance margin represents the amount of equity the investor must maintain in the margin account. Regulation T sets the minimum amount at 25 percent, but many brokerage firms will require a higher rate. Continuing with the same example used for the initial margin, imagine the maintenance margin is 30 percent. The value of the margin account is the same as the value of the 1,000 shares. The investor's equity will always be $3,500 less than the value of the shares since the investor must pay back that money.
Suppose the price of the stock dropped from $10 to $5. Then, the value of the margin account would drop to $5,000. The investor's equity would be only $1,500, or 30 percent of the value of the margin account. If the price of the stock declined further, the investor would hold less than 30 percent equity. At that point, the investor would receive a margin call from the brokerage firm. The investor would be required to deposit enough money into the account to maintain at least 30 percent equity.
The maintenance margin exists to protect brokerage firms from investors defaulting on their loans. Keeping a buffer between the amount of the loan and the value of the account lessens the firm's risk. The risk for brokerage firms is higher when stock prices plummet dramatically.
Key Differences
The first and most critical difference is that the initial margin limits the maximum leverage for successful stock investments. For instance, suppose the initial margin requirement is 50%. Then, the investor starts with 2:1 leverage. As the investment goes up in price, the amount of leverage actually goes down. In order to get to the 4:1 leverage provided by the maintenance margin, the investor must lose a substantial amount of money. As a practical matter, most speculators using leverage also use stop-loss orders and would sell well before that point.
Since the relatively high initial margin requirement applies in most cases, stock investors seeking more leverage are better off looking elsewhere. Leveraged ETFs commonly offer 3:1 leverage, and they never face margin calls. Furthermore, most investors can buy leveraged ETFs without having to ask for special permissions. Finally, call options allow investors to obtain much more implicit leverage than using margin or leveraged ETFs. Call options also provide better downside risk control, but buying them requires approval from a brokerage.
Another key difference is that maintenance margin requirements force investors to sell (or add more funds) before they lose everything. That means it is not possible to buy and hold a position using margin. The initial margin limit does not, in and of itself, prevent an investor from clinging to a losing investment until the end.
