A margin trade requires borrowing money from your broker. Borrowing money to trade stocks or other securities has a lot of appeal for investors because of leverage, which simply means you put up less money to make a trade than a cash purchase requires. Your broker wants assurance that the money you borrow will be returned. That’s when your margin equity becomes important.
Margin equity is the amount of money that remains in a brokerage margin account, either in the form of cash or securities, after certain items are subtracted. To calculate margin equity, subtract money borrowed from your broker and the value of any in-the-money covered call options you have sold. Covered calls must be subtracted because an in-the-money option may be exercised by the owner of the call option contract, so the stock held to cover the call option may be removed from your account at any time.
Margin accounts are trading accounts with borrowing privileges. That is, your broker will lend you part of the money you need to buy stocks or other securities. You have to have a margin account to buy securities on margin, to sell stock short, and to use some types of options strategies. The Financial Industry Regulatory Authority sets a minimum of $2,000 for margin accounts. Your broker may ask for a larger minimum balance. When you want to make a trade that requires borrowing, the amount of money you put up is called your margin requirement. Only your margin equity may be used to meet margin requirements.
The amount of margin required depends on the type of transaction you want to make and on your broker’s policy. For trading commodities or foreign currency, you may need only a small percentage of the cash value of the securities involved. The Federal Reserve Board sets a 50-percent margin for stock trades, but your broker may ask for more. For example, if you want to buy 500 shares of a stock at $20 per share, the cash value is $10,000. If your broker wants 60 percent, the margin equity in your account must be at least $6,000. If you don’t have that much, you must buy fewer shares or deposit enough money into the account to bring your margin equity up to the required amount.
Your broker will require you to keep a minimum maintenance margin. If price fluctuations cause your margin equity to fall below the minimum maintenance margin, your broker can close out your trade. Brokers typically issue a margin call so you have a chance to deposit additional funds, but are not legally required to do so. For stock trading, markets like the New York Stock Exchange set 25 percent as a minimum maintenance margin. Suppose you bought 500 shares of a stock at $20 per share with a 60-percent margin. You borrow the other 40 percent, or $4,000. If the stock price falls to $10 per share, its cash value is reduced to $5,000. You still owe $4,000, so your margin equity is down to just $1,000. That’s less than 25 percent of the cash value of the stock, so your broker will issue a margin call or simply close out your trade.