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Margin (Finance)
Margin (Finance)
In finance, margin is the collateral that a holder of a financial instrument has to deposit with a counterparty
(most often their broker or an exchange) to cover some or all of the credit risk the holder poses for the
counterparty. This risk can arise if the holder has done any of the following:
The collateral for a margin account can be the cash deposited in the account or securities provided, and
represents the funds available to the account holder for further share trading. On United States futures
exchanges, margins were formerly called performance bonds. Most of the exchanges today use SPAN
("Standard Portfolio Analysis of Risk") methodology, which was developed by the Chicago Mercantile
Exchange in 1988, for calculating margins for options and futures.
Margin account
A margin account is a loan account with a broker which can be used for share trading. The funds available
under the margin loan are determined by the broker based on the securities owned and provided by the
trader, which act as collateral for the loan. The broker usually has the right to change the percentage of the
value of each security it will allow toward further advances to the trader, and may consequently make a
margin call if the balance available falls below the amount actually utilised. In any event, the broker will
usually charge interest and other fees on the amount drawn on the margin account.
If the cash balance of a margin account is negative, the amount is owed to the broker, and usually attracts
interest. If the cash balance is positive, the money is available to the account holder to reinvest, or may be
withdrawn by the holder or left in the account and may earn interest. In terms of futures and cleared
derivatives, the margin balance would refer to the total value of collateral pledged to the CCP (central
counterparty clearing) and or futures commission merchants.
Margin buying
Margin buying refers to the buying of securities with cash borrowed from a broker, using the bought
securities as collateral. This has the effect of magnifying any profit or loss made on the securities. The
securities serve as collateral for the loan. The net value—the difference between the value of the securities
and the loan—is initially equal to the amount of one's own cash used. This difference has to stay above a
minimum margin requirement, the purpose of which is to protect the broker against a fall in the value of
the securities to the point that the investor can no longer cover the loan.
Margin lending became popular in the late 1800s as a means to finance railroads.[1] In the 1920s, margin
requirements were loose. In other words, brokers required investors to put in very little of their own money,
whereas today, the Federal Reserve's margin requirement (under Regulation T) limits debt to 50 percent.
During the 1920s leverage rates of up to 90 percent debt were not uncommon.[2] When the stock market
started to contract, many individuals received margin calls. They had to deliver more money to their brokers
or their shares would be sold. Since many individuals did not have the equity to cover their margin
positions, their shares were sold, causing further market declines and further margin calls. This was one of
the major contributing factors which led to the Stock Market Crash of 1929, which in turn contributed to
the Great Depression.[2] However, as reported in Peter Rappoport and Eugene N. White's 1994 paper
published in The American Economic Review, "Was the Crash of 1929 Expected",[3] all sources indicate
that beginning in either late 1928 or early 1929, "margin requirements began to rise to historic new levels.
The typical peak rates on brokers' loans were 40–50 percent. Brokerage houses followed suit and
demanded higher margin from investors".
For example, Jane buys a share in a company for $100 using $20 of her own money and $80 borrowed
from her broker. The net value (the share price minus the amount borrowed) is $20. The broker has a
minimum margin requirement of $10. Suppose the share price drops to $85. The net value is now only $5
(the previous net value of $20 minus the share's $15 drop in price), so, to maintain the broker's minimum
margin, Jane needs to increase this net value to $10 or more, either by selling the share or repaying part of
the loan.
Short selling
Short selling refers to the selling of securities that the trader does not own, borrowing them from a broker,
and using the cash as collateral. This has the effect of reversing any profit or loss made on the securities.
The initial cash deposited by the trader, together with the amount obtained from the sale, serve as collateral
for the loan. The net value—the difference between the cash amount and the value of loan security—is
initially equal to the amount of one's own cash used. This difference has to stay above a minimum margin
requirement, the purpose of which is to protect the broker against a rise in the value of the borrowed
securities to the point that the investor can no longer cover the loan.
For example, Jane sells a share of stock she does not own for $100 and puts $20 of her own money as
collateral, resulting $120 cash in the account. The net value (the cash amount minus the share price) is $20.
The broker has a minimum margin requirement of $10. Suppose the share price rises to $115. The net value
is now only $5 (the previous net value of $20 minus the share's $15 rise in price), so, to maintain the
broker's minimum margin, Jane needs to increase this net value to $10 or more, either by buying the share
back or depositing additional cash.
Margin strategies
Enhanced leverage is a strategy offered by some brokers that provides 4:1 or 6+:1 leverage. This requires
maintaining two sets of accounts, long and short.
Example 1
An investor sells a put option, where the buyer has the right to require the seller to buy his
100 shares in Universal Widgets S.A. at 90¢. He receives an option premium of 14¢. The
value of the option is 14¢, so this is the premium margin. The exchange has calculated,
using historical prices, that the option value will not exceed 17¢ the next day, with 99%
certainty. Therefore, the additional margin requirement is set at 3¢, and the investor has to
post at least 14¢ (obtained from the sale) + 3¢ = 17¢ in his margin account as collateral.
Example 2
Futures contracts on sweet crude oil closed the day at $65. The exchange sets the
additional margin requirement at $2, which the holder of a long position pays as collateral
in his margin account. A day later, the futures close at $66. The exchange now pays the
profit of $1 in the mark-to-market to the holder. The margin account still holds only the $2.
Example 3
An investor is long 50 shares in Universal Widgets Ltd, trading at 120 pence (£1.20) each.
The broker sets an additional margin requirement of 20 pence per share, so £10 for the
total position. The current liquidating margin is currently £60 "in favour of the investor".
The minimum margin requirement is now -£60 + £10 = -£50. In other words, the investor
can run a deficit of £50 in his margin account and still fulfil his margin obligations. This is
the same as saying he can borrow up to £50 from the broker.
Margin call
The broker may at any time revise the value of the collateral securities (margin) after the estimation of the
risk, based, for example, on market factors. If this results in the market value of the collateral securities for a
margin account falling below the revised margin, the broker or exchange immediately issues a "margin
call", requiring the investor to bring the margin account back into line. To do so, the investor must either
pay funds (the call) into the margin account, provide additional collateral, or dispose some of the securities.
If the investor fails to bring the account back into line, the broker can sell the investor's collateral securities
to bring the account back into line.
If a margin call occurs unexpectedly, it can cause a domino effect of selling, which will lead to other margin
calls and so forth, effectively crashing an asset class or group of asset classes. The "Bunker Hunt Day"
crash of the silver market on Silver Thursday, March 27, 1980, is one such example. This situation most
frequently happens as a result of an adverse change in the market value of the leveraged asset or contract. It
could also happen when the margin requirement is raised, either due to increased volatility or due to
legislation. In extreme cases, certain securities may cease to qualify for margin trading; in such a case, the
brokerage will require the trader to either fully fund their position, or to liquidate it.
For instance, assume that an investor bought 1,000 shares of a company each priced at $50. If the initial
margin requirement were 60%, then stock equity = $50 × 1,000 = $50,000 and leveraged dollars (or
amount borrowed) = $50,000 × (100% − 60%) = $20,000.
If the maintenance margin changed to 25%, then the customer would have to maintain a net value equal to
25% of the total stock equity. That means that he or she would have to maintain net equity of $50,000 ×
0.25 = $12,500. At what price would the investor get a margin call? For stock price P the stock equity
would be (in this example) 1,000P.
So if the stock price dropped from $50 to $26.67, then the investor would be called to add additional funds
to the account to make up for the loss in stock equity.
Reduced margins
Margin requirements are reduced for positions that offset each other. For instance spread traders who have
offsetting futures contracts do not have to deposit collateral both for their short position and their long
position. The exchange calculates the loss in a worst-case scenario of the total position. Similarly an
investor who creates a collar has reduced risk since any loss on the call is offset by a gain in the stock, and
a large loss in the stock is offset by a gain on the put; in general, covered calls have less strict requirements
than naked call writing.
Margin-equity ratio
The margin-equity ratio is a term used by speculators, representing the amount of their trading capital that is
being held as margin at any particular time. Traders would rarely (and unadvisedly) hold 100% of their
capital as margin. The probability of losing their entire capital at some point would be high. By contrast, if
the margin-equity ratio is so low as to make the trader's capital equal to the value of the futures contract
itself, then they would not profit from the inherent leverage implicit in futures trading. A conservative trader
might hold a margin-equity ratio of 15%, while a more aggressive trader might hold 40%.
Return on margin
Return on margin (ROM) is often used to judge performance because it represents the net gain or net loss
compared to the exchange's perceived risk as reflected in required margin. ROM may be calculated
(realized return) / (initial margin). The annualized ROM is equal to
For example, if a trader earns 10% on margin in two months, that would be about 77% annualized
Sometimes, return on margin will also take into account peripheral charges such as brokerage fees and
interest paid on the sum borrowed. The margin interest rate is usually based on the broker's call.
See also
Badla system (Indian stock markets)
Collateral management
Credit default swap
Leverage (finance)
LIBOR
Margin at risk
MVA, the x-Valuation Adjustment related to Margin
Portfolio margin
Repurchase agreement
Special memorandum account
Short selling
References
1. Ruby Day (26 August 2019). "Blue Ocean Strategy & Finance: Margin Lending" (https://ww
w.innowiki.org/margin-lending/). Innowiki. Retrieved 4 September 2022.
2. Cundiff, Kirby R. (January 2007). "Monetary-Policy Disasters of the Twentieth Century" (htt
p://www.thefreemanonline.org/featured/monetary-policy-disasters-of-the-twentieth-century/).
The Freeman Online. Retrieved 10 February 2009.
3. Rappoport, Peter; White, Eugene N. (March 1994). "Was the Crash of 1929 Expected". The
American Economic Review. United States: American Economic Association. 84 (1): 271–
281. JSTOR 2117982 (https://www.jstor.org/stable/2117982).