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Glossario

Margin (collateral)

Categoria — Nozioni Generali
By Maxim Zenkov, Head of Indian Fixed Income Market of Cbonds
Updated June 28, 2024

What is Margin?

In finance, margin represents the collateral an investor must deposit with their broker or stock exchange to mitigate credit risk. This risk arises when investors borrow cash to acquire financial instruments, engage in short selling by borrowing instruments, or strike derivative contracts.

Buying on margin is a common practice. It involves investors purchasing assets by borrowing the balance from a broker. This transaction necessitates an initial payment to the broker, where marginable securities in the brokerage account serve as a collateral.

Margin

How Margin Works

"Buying on margin" requires a specialized margin account, distinct from a standard brokerage account. Via the margin account, the broker extends a loan to the investor, enabling him to purchase more securities than their account balance would otherwise afford.

Essentially, employing margin for securities acquisition is akin to leveraging the existing cash or securities in your account as collateral for a loan. This collateralized loan carries an interest rate that the investor must service. When securities are sold, the proceeds first go toward repaying the loan, and the remaining amount is retained by the investor.

The use of borrowed funds means that both losses and gains are magnified. The strategic advantage of margin trading lies in scenarios where the investor expects a higher return on their investment than the interest paid on the loan.

For instance, consider an initial margin requirement of 50% for a margin account. If an investor aims to buy $20,000 worth of securities, their margin would be $10,000, and the remaining amount could be borrowed from the broker. This showcases the leverage potential of margin trading in amplifying investment opportunities.

Margin trading is subject to strict regulations imposed by the Financial Industry Regulatory Authority (FINRA) and the Securities and Exchange Commission (SEC). These regulations dictate the minimum deposit requirements, the permissible borrowing limits, and the mandatory account balance to be maintained during margin trading activities. Compliance with these rules ensures the stability and integrity of the margin trading system.

Benefits and Risks Associated with Margin

Benefits

  1. Greater Gains through Leverage. By borrowing funds, investors can amplify their purchasing capacity, potentially leading to higher returns.

  2. Increased Purchasing Power. Investors can control a more substantial position in the market than their existing account balance would allow, opening up more significant investment opportunities.

  3. Flexibility Compared to Other Loans. In comparison to traditional loans, margin loans often provide more flexibility. Many investors use the borrowed funds for various investment strategies, which can make their financial approach more multi-faceted.

  4. Self-Fulfilling Opportunity Cycle. As the collateral value increases, it can offer more leverage opportunities, potentially leading to a positive feedback loop of increased gains.

Risks

  1. Greater Losses through Leverage. The flip side of increased gains is the potential for greater losses. Leverage magnifies both profits and losses, making it a double-edged sword. If the market moves unfavorably, losses can escalate quickly.

  2. Account Fees and Interest Charges. Utilizing margin incurs additional costs, including account fees and interest charges on the borrowed funds. These expenses can impact overall returns and should be carefully considered.

  3. Margin Calls. A significant risk associated with margin trading is the possibility of margin calls. If the account value falls below a certain level, the investor may be required to add more funds to meet margin requirements.

  4. Forced Liquidations and Securities Selloffs. In extreme cases, if the value of the account declines substantially, it can trigger forced liquidations. This entails the sale of securities, often at a loss, to cover outstanding loan amounts. This forced selling can exacerbate losses and disrupt an investor's portfolio strategy.

Interest on Margin

When an investor opts to leverage their investments by borrowing funds from a brokerage to purchase securities, they incur an obligation to pay interest on the provided funds.

Investors have the flexibility to manage interest payments. They can choose to make direct interest payments to the brokerage, bypassing automatic deductions from their margin account. However, it's crucial to note that failure to repay the loan and the associated interest promptly can lead to the accumulation of debt and interest charges over time.

This scenario has potential repercussions, impacting the investor's capacity to generate sufficient returns in the future. Margin accounts, designed for short-term investments, serve as a tool for investors to capitalize on short-term security movements rather than serving as vehicles for long-term investments. Therefore, effective management of interest payments is essential for investors looking to optimize their returns within the dynamics of margin trading.

Margin Requirements

  • Current Liquidating Margin. The current liquidating margin represents the value of a security's position if liquidated (sold) immediately. For short positions, it signifies the funds needed to repurchase the security, while for long positions, it represents the potential funds that can be obtained by selling it.
  • Variation Margin or Mark to Market. The variation margin, also known as mark-to-market, serves as a daily settlement of profits and losses. In futures trading, assets are marked-to-market daily, which means comparing the current price with the previous day's. Profits or losses for the day are then paid to or debited from the holder by the futures exchange. This practice is facilitated by the exchange acting as the central counterparty, ensuring a balance between long and short contracts. Certain exchange-traded derivatives, such as options on futures contracts, follow a similar mark-to-market process.

  • Premium Margin for Option Sellers. Sellers of options must deliver the underlying security upon option exercise. To meet this commitment, they are required to deposit collateral known as premium margin. This margin is equivalent to the collateral needed to repurchase the option and close out the position.

  • Additional Margin for Potential Losses. Additional margin serves the purpose of safeguarding against potential losses in the position on the subsequent trading day. This calculation is based on the potential loss in a worst-case scenario, providing an extra layer of protection.

  • SMA and Portfolio Margins. In the realm of U.S. and NYSE regulatory margin requirements, alternative rules such as SMA (Special Memorandum Account) and portfolio margins offer flexibility. These frameworks present alternative approaches to calculating and maintaining margin requirements, providing traders and investors with different options to manage their positions within regulatory guidelines.

Margin-Equity Ratio

The margin-equity ratio is a crucial metric employed by speculators, representing the portion of their trading capital held as margin at any given time. It serves as a strategic measure to balance risk and leverage in the dynamic realm of trading.

It is generally unwise for traders to hold 100% of their capital as margin, as this substantially heightens the risk of losing their entire capital at some point. Striking the right balance is key. Conversely, if the margin-equity ratio is too low, equating the trader's capital to the value of their assets, the potential for profit from the leverage is diminished.

A prudent and conservative trader might maintain a margin-equity ratio of around 15%. This approach allows for a reasonable level of leverage while mitigating the risk of significant capital loss. On the other hand, a more aggressive trader might opt for a higher margin-equity ratio, say around 40%, seeking to maximize potential returns but accepting a higher level of risk.

Margin Call

When engaging in margin trading, the market value of certain stocks utilized as collateral for a margin loan fluctuates alongside market changes, but the borrowed amount remains constant. Consequently, if the stock value decreases, the equity in the position relative to the size of the margin debt diminishes.

Understanding this is crucial, as brokerage firms mandate that margin traders uphold a specified percentage of equity in their account as collateral against the purchased securities. This percentage typically ranges from 30% to 35%, contingent on the type of securities and the brokerage firm.

Imagine owning $10,000 in stock and acquiring an additional $10,000 on margin. Your equity in the position is initially $10,000 ($20,000 total value less $10,000 in margin debt), resulting in an equity ratio of 50%. If the total value of your stock position declines to $12,000, your equity would decrease to $3,000 ($13,000 in stock less $10,000 in margin debt), yielding an equity ratio of around 23%.

Should your equity fall below the required level due to market fluctuations, your brokerage firm will issue a margin call (also known as a maintenance call). In response, you are obligated to promptly deposit an extra amount of marginable securities into your account to restore your equity to the mandated level.

In this scenario, if the brokerage firm's maintenance requirement is 30%, the account's minimum equity would be $3,900 (30% of $13,000 = $3,900). Consequently, you would need to deposit either $900 in cash ($1,000 + $900 = $1,800), or $1,286 of fully paid marginable securities (calculated as the $900 shortfall divided by [1 – the 0.30 equity requirement] = $1,286), or a combination of both to meet the margin call.

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