What to Expect From Margin Account Requirements
Margin trading can be a potent ally. It’s an easy way to enhance a portfolio’s earning power. But first, it’s important to know about margin account requirements.
Before getting started margin trading, investors have to fulfill certain obligations. While requirements can vary by brokerage, there are some basic rules that they are all required to follow.
Current prerequisites for a healthy margin account were put in place in 2016. These are scheduled to remain effective until at least 2021. So once an investor looking to open a margin account fulfills these obligations, they should be good to go for a while.
But setting up a margin account is just the beginning. In order to continue trading on margin, an investor needs to make sure their account is maintained. These specifications were established by the Financial Industry Regulatory Authority (FINRA). And while this all might seem complicated at first, it’s pretty straightforward once you get the hang of it.
First, you have to set up a margin account with a brokerage firm. This part is probably the easiest. You’ll receive a form that will outline the individual brokerage’s guidelines for a healthy margin account and explain its interest rate structure. All that’s usually required here is to sign and date it.
Once the account is officially established, it’s time to get it up and running. The margin account agreement form will show you exactly what is required. But if you’re just getting started, FINRA has well-established baselines to consider.
FINRA Rule 4210 for Margin Account Requirements
In order to start using a margin account, one of the requirements is that there needs to be at least $2,000 in equity deposited into the account. This can be in the form of cash or securities. And again, $2,000 is just the minimum. You can make a deposit of holdings or equity much greater than this if you want.
What comes next is where Regulation T comes into play. An initial deposit will grant the investor trading on margin “up to 50 percent of the total purchase price of a margin security for new, or initial, purchases.” In other words, once the account minimum of $2,000 is established, it grants an investor access to $4,000 in investable capital. These figures can vary depending on the brokerage firm, though. So it’s always important to double check the margin account agreement.
But again, this is just based on the bare minimum. If a margin account has $20,000 deposited into it, the investor can have access to $40,000 in investable funds. This doubling of investible capital is essentially a loan given by the brokerage. And because it’s a loan, it does accrue interest. So keep that in mind.
Maintaining a Healthy Margin Account
Establishing a margin account is only half the battle. It’s like buying a car. You can drive it, take it where you want and do whatever you want with it. You can paint it pink with purple polka dots if you want to. But in order to keep it going, you’ve got to maintain it and make payments on it. Margin accounts operate in a similar way.
Rule 4210 mentioned above doesn’t just apply to opening accounts. It also says the account must stay healthy. If it doesn’t, the brokerage firm can “repossess” any assets in the account and liquidate them… just like a bank can repossess a car if the loan is defaulted on.
In the case of a margin account, both the New York Stock Exchange and FINRA require the equity within a margin account to be worth at least 25% of the total value of the securities purchased on margin. That being said, some brokerages have higher maintenance requirements.
If the account value falls below 25%, it’s deemed unhealthy. In turn, the brokerage can initiate a margin call. This is essentially the brokerage repossessing and liquidating any securities held and returning the account to a healthy status.
If the liquidation of those securities doesn’t bring in enough money to return it to healthy status, the brokerage can also charge a commission for those transactions. And the investor is held fully accountable for financial losses that occur.
Calculating the account value is simple. Just divide the total margin loan by the maintenance margin requirement (MMR). So if your brokerage requires the baseline $2,000, and the value of the holdings purchased on margin retain at least 25% of their value, it is considered “healthy.” Here’s what that equation looks like:
Account Value = (Margin Loan) / (1 – MMR)
Into the Margin Danger Zone
If the account value of what’s purchased on margin falls below the 25% mark, the brokerage can and probably will initiate a margin call. And no warning is needed.
This is why it’s imperative to keep a close eye on a margin account. And because there is some variance, it’s equally important to know the margin account requirements set by your brokerage.
For instance, let’s say someone bought 400 shares of Nokia (NYSE: NOK) with $2,000 of margin. In this case, the cost of each share was $5. If the cost of sharesstock price falls all the way down to $1.25 a share, the margin account is considered unhealthy. And the brokerage will most likely issue a margin call.
To prevent this, our unlucky investor will need to add more capital to their margin account. And they will most likely need to either buy more worthwhile securities or buy more shares of Nokia to “average down” the purchase price.
Margin Account Requirements: The Bottom Line
Margin accounts can add a powerful short-term boost to an investment portfolio when used properly. If used in conjunction with a cyclical strategy, trading on margin can turn a solid 50% gain into a full-on doubling of money.
This is the same reason day traders often rely on margin accounts to turn a few small trades into a few big winners. But these are only a couple of the strategies used to harness the power of margin trading. Just be sure to first take a close look at your margin account agreement. And make sure you know exactly what your margin account requirements are before getting started.
If you’re ready to start putting a margin account to work, sign up for the free Trade of the Day e-letter. Every day the markets are open, these investment experts deliver invaluable insight and point investors towards the trends that will be moving the markets before they happen.