Trading on margin involves additional risk, so before placing any trades, be sure you understand the requirements and industry regulations that govern margin borrowing.
First, it's important to understand that margin is a privilege, not a right. A margin account is essentially a loan made by a brokerage firm to an account owner. Therefore, similar to the way you apply for a mortgage; you must first complete a margin account application and be approved. Your broker will review your annual income, net worth, estimated liquid net worth and possibly your credit history to make a determination as to whether you have the financial resources to manage a margin account.
Once your account has been approved for margin, it is subject to the rules of the Federal Reserve Board, the Financial Industry Regulatory Authority (FINRA) and securities exchanges such as the New York Stock Exchange, as well as your own brokerage firm's margin policies. In many cases, a brokerage firm's margin policies may be more stringent than those of the regulators.
In order to purchase securities on margin and continue to hold them in your margin account, you must meet the following margin requirements:
Initial margin requirement
For new purchases, the initial Reg T margin requirement is 50% of the total purchase amount. Therefore, if you wanted to buy $10,000 of ABC stock on margin, you would first need to deposit $5,000 in your account or have equity equal to $5,000 in your account. Margin accounts require a minimum of $2,000 in net worth to establish a long stock position.
House margin requirement
FINRA Rule 4210 requires that you maintain a minimum of 25% equity in your margin account at all times. Most brokerage firms maintain margin requirements that meet or, in many cases, exceed those set forth by regulators. They do this to protect themselves from market risk and the risk that certain customers will incur a margin debt that they are unable to pay back.
Firms typically determine margin requirements by assessing risk at the security level or at the account level. Calculating requirements at the security level takes into account a security’s price, volatility, and number of outstanding shares, along with many other factors. This information is used to create a single margin requirement across the firm. The main benefit of this method is the simplicity in maintaining and communicating this information to customers.
Calculating margin requirements at the account level may provide a more accurate and true representation of risk. This method goes beyond the individual security level characteristics and analyzes risk and the corresponding margin requirements based on each customer's overall account structure. The criteria used to assess this risk may vary from broker to broker, but generally firms use factors such as account concentration, security liquidity, ownership concentration, industry concentration and a security's volatility. Additional factors pertaining to certain securities, such as leveraged ETFs or those from distressed sectors and issuers, could increase the house requirements for these securities. These requirements can change at any time, so be sure you understand your firm's unique margin policies before you start trading on margin.
Margin requirements in action
Understanding the potential benefits, risks, and requirements of maintaining a margin account is just the first step in getting started with margin. Before you proceed, you also need to know what can happen when the market moves against your margin positions. For more on this topic, please read Avoiding and Managing Margin Calls.