Margin accounts let investors borrow money from their broker to purchase stock. This leverage enables them to realize higher returns, but the same leverage increases risk. If the equity in an account falls below a certain threshold, brokers may issue a margin call or liquidate stock positions to protect their lent money with little or no notice.
For example, suppose that one investor invests $1,000 to purchase 100 shares of a $10 stock and a second investor $1,000 and borrows $500 from their broker to purchase 150 shares of the same stock. If the stock rises 5%, the second investor’s return is 2.5% higher than the first investor (less interest). If the stock falls 5%, the second investor’s return is 2.5% lower than the first investor. And if it falls too far, the broker could liquidate the position to repay the loan, resulting in a large loss.
In this article, we will look at Regulation T, FINRA Rule 4210 and other regulations that govern margin trading, as well as how these regulations impact margin traders.
Margin trading is a double-edged sword that increases both potential risks and returns.
What Is Regulation T?
Regulation T governs the extension of credit by broker-dealers, including margin requirements.
Regulation T states that brokers or dealers can lend a customer up to 50% of the total purchase price of a margin security for new, or initial, purchases, provided they deposit at least $2,000 in cash into the account. For instance, if you open a margin account with $10,000 in cash, you could purchase up to $20,000 worth of stock with a $10,000 loan.
On a more technical level, Regulation T also gives an investor a maximum of four business days to pay for securities in a cash or margin account. If the payment due is more than $1,000 and isn’t received in time, the broker must liquidate the position to apply for and receive an extension from a designated examining authority, such as FINRA.
Initial margin requirements for stocks have been 50% since 1974, but Regulation T enables the Federal Reserve to change these requirements. Lowering margin requirements increases systemic risk by expanding buying power, while raising margin requirements reduces systemic risk by limiting leverage. It’s effectively a monetary policy tool to control risk.
Supplemental Regulations
The Financial Industry Regulatory Authority, or FINRA, has supplemental margin account rules, and brokers are free to implement any of their own rules.
Download our free margin trading profit/loss worksheet to see how margin trading impacts your performance.
FINRA Rule 4210 states that a customer’s equity must not fall below 25% of the current market value of the securities in the account. If it does, the customer must either deposit more funds or securities to maintain the 25% requirement or the broker-dealer is required to liquidate the securities in the customer’s account to bring equity back to the required level.
Brokers may have their own margin requirements that are stricter than Regulation T and Rule 4210. For instance, many brokers require at least 30% equity. Equity requirements may also change during extreme market volatility, which means that it’s important to keep an eye on equity levels in margin accounts at all times to avoid a margin call.
Traders that wish to open margin accounts must apply for them with their brokers. The margin agreement that you sign contains important details about the loan terms, including maintenance margin terms and conditions. It’s important to read through these agreements and take the time to understand how the specific broker handles margin trades.
How to Avoid Margin Calls
The liquidation of securities to meet margin requirements is referred to as a margin call or margin request.
Brokers have some discretion when it comes to margin calls. Some brokers will attempt to contact you to request additional equity and keep the positions open, while others take immediate action to increase equity by liquidating securities. You can satisfy a margin call by depositing cash or marginal securities (e.g. paid for stock), or by selling stock.
Margin calls can have significant financial implications. For instance, you may owe capital gains taxes on stocks that the broker liquidates and it could throw off your wider trading strategy. It’s important to prepare for volatility by maintaining a cash cushion or liquid resources, as well as monitor your account daily using margin calculators.
Traders should ensure that their trading strategy controls for these risks. For example, you may want to only use margin or short-term trades to minimize interest expenses or set higher maintenance margins for yourself to limit margin calls. You may also decide to trade only high-quality stocks with predictable volatility on margin rather than riskier small companies.
In our proprietary covered call strategy, the Snider Investment Method, we set up accounts with the ability to use margin when available, but use it sparingly. It gives our clients the ability to boost the income they generate in their portfolio. Using a form of dollar cost averaging, our clients can make additional purchases of stock when the market experiences declines and we see an opportunity for reversal. We manage the risk of margin by only borrowing a small percentage of what’s available and re-evaluate monthly after each expiration.
The Bottom Line
Regulation T and FINRA Rule 4210 impose margin requirements that have a big impact on traders. Before trading on margin, it’s important to take the time to understand the rules imposed by your broker and ensure that you have the right risk management in place to avoid margin calls. Novice traders should also avoid margin accounts until they’re comfortable.
Don’t forget to download our free margin trading profit/loss worksheet to see how margin trading impacts your performance.
If you’re an investor looking to generate income for retirement, you may want to consider selling covered call options as an alternative to risky strategies like using margins. The covered call strategy involves writing call options against an existing long position and collecting the premiums as income over time — a dividend of sorts.
The Snider Method is designed to simplify this process by providing a comprehensive strategy that seeks to optimize a portfolio for both safety and income. By providing specific guidelines for selecting stocks and options, the system takes a lot of guesswork out of covered call writing, as well as eliminates emotional biases that can hinder performance.
Sign up for our free e-course to learn the basics and get started today! Or, learn more about our asset management services for a hands-off approach.
