Calculating Maintenance Margin
In the trading arena, you need to deposit some collateral with the counterparty; in this case, a broker or an exchange; in order to cover the credit risks associated with investing activities. This is called margin in finance and the corresponding loan account is a margin account. The credit risk can come from several activities, such as entering into a leveraged position in the market, selling securities short or entering into a derivatives contract. The collateral in the margin account can be cash or securities. This represents the funds available to a trader for further investments.
The minimum amount of collateral or equity that needs to be maintained in the margin account is called the maintenance margin, maintenance requirement or minimum maintenance.
The Need for Margin Accounts
Through margin accounts, traders can borrow money from their brokers to get into magnified positions. They are able to trade on leverage, to enter trades that are larger than the capital in their account. However, this means that while gains might be magnified, losses are magnified too. Due to this, the act of purchasing securities on margin is regulated by governing bodies. The maintenance margin is also one such rule, which quantifies the amount of money that should always remain in an account to counter such risks.
Margin trading is regulated by agencies like the Financial Industry Regulatory Authority (FINRA) and Financial Conduct Authority (FCA), to avoid potentially crippling losses for both traders and brokers. Brokerages are required to follow the minimum norms and guidelines, but other terms like interest rate payments and repayment terms vary from broker to broker. They have to get margin agreements signed by investors before trading. Maintenance margin comes into effect once a trader buys a security on margin.
According to the FINRA and NYSE, the maintenance margin is 25% of the total value of securities in the margin account, which might extend to 30% or even 40% in case of some brokerage firms.
Calculation of the Maintenance Margin
The stock markets usually require maintenance margins of 25%, which might be higher for some brokerages. Traders could get a margin call, if the stock price declines, causing the equity in the accounts to drop very low. This is why it is important to understand the calculation of the maintenance margin for each position or trade.
Suppose a trader buys stock at $40 per share, with a 50% margin requirement. Then, the amount borrowed from the broker would be equal to 40x (1-0.50) which is $20 per share. This is the amount of money per share borrowed by the trader from their broker, for the margin trade.
Now, by subtracting the maintenance margin requirement from 1, the maximum allowable percentage of funds that can be borrowed is calculated. Suppose the maintenance margin is 25%. In this case, the maximum allowable percentage for borrowed funds will be (1-0.25), i.e., 75%.
So, the maintenance margin will be the amount of money per share borrowed, divided by the maximum allowable percentage of borrowed funds. According to our prior calculations, that stands at $20/0.75, which is $26.67. This is the maintenance margin, and when stock prices decline to this level, or even below this level, traders will be issued a margin call, after which they will be required to deposit more money.
Maintenance Margin in Forex Terms
For forex trading accounts as well, traders have to follow maintenance margins. Brokerage firms will provide a leverage limit or margin ratio. Regulatory bodies in different countries have imposed rules regarding this margin ratio, in order to protect investor interests. Here too, the maintenance margin is typically set at 25% to 40% or higher, of the equity used in a trade.
Let us suppose a trader purchases 100 units of the GBP/USD pair at US$1.3041. The broker provides a margin ratio of 4:1. Here, the equity of transaction will be 1.3041/4, which is US$0.3260. This will be the equity provided by the trader, while the rest will come from the broker. Even with the leverage provided by the broker, the trader will have to maintain a certain amount of funds in their account, till the units are sold off.
So, if the broker sets a maintenance margin of 40%, the trader will have to keep 40% of their total equity in the account at all times, till the trade is settled. Here, the maintenance margin would be 40% of US$0.3260, which is US$0.1304.
In case the funds drop below this level, the trader will be asked to deposit the difference between the current balance and the required margin. Some brokers might sell certain holdings in the account, at the current market price, to achieve the balance. If the market prices are lower than the original investment value, it would mean a loss for the trader. This is why maintenance margin terms have to be diligently understood and followed before opening a trade.
Initial Margin vs. Maintenance Margin
Maintenance margin is not to be confused with initial margin. Initial margin requirements stipulate the amount of margin required at the time of purchasing a security. The US Federal Reserve Regulation T specifies the initial margin rate to be 50%. So, if someone wants to purchase 500 shares of a stock valued at $10 per share, the total price would be $5,000. Now, according to the 50% initial margin requirement of the Fed, a broker can fund $2,500 of the $5,000, while depositing the rest in their account.
The initial margin amount varies from brokerage to brokerage, with some even asking traders to deposit a higher amount upfront. For instance, the trader might be required to deposit $3,000, while the brokerage deposits the remaining $2,000. Once the 500 shares have been purchased, the maintenance margin requirements will come into play. It will be the collateral requirement until the position is closed.
The need for maintenance margin is one way to prevent investors from defaulting on their loans, thereby protecting the brokerage firms from counterparty risk.
