How Does Maintenance Margin Work: Explained By An Expert
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If you have been trading for a while, you must know that trading with leverage can be worth it if you want to increase your current value. But then you must have also faced the dilemma of stop-out. What if your loss covers your entire margin, and you are forced to get out of the trade? This is where the role of maintenance margin comes in.
Margin accounts are different from other trading accounts in several ways. First, a margin account allows leveraged purchases instead of letting the trader make frequent trades. This means the trader can buy equities, bonds, or options for more than they have in their account and only pay a deposit on the deal. Instead, they borrow the rest of the cash required to purchase from their broker. This warranty deposit is called the margin and serves as collateral for the loan from the broker.
To understand the concept of maintenance margin in depth, we have got Ezekiel Chew to share his take on it with us. Ezekiel is the founder and CEO of Asia Forex mentor, a website that provides forex education to retail investors. He is also a professional forex trader and has been trading the currency market for over a decade. In this expert guide, we will discuss everything about maintenance margin, including how it works, why it is necessary, the advantages and risks associated with it, and more.
So let’s dive right in.
What is Maintenance Margin
A maintenance margin is the minimum amount of equity a trader needs to maintain in their account to protect themselves against potential losses. A trader must keep this level of equity, or their broker will automatically close out the position, ending their trade early.
Margin can be viewed as an interest-free loan from the brokerage firm, with the amount and terms depending on the number of stocks you have in your portfolio. The broker purchases the instruments you want to trade and deposits the amount they pay into your account. Then, you sell your position and return the funds to the broker when you have enough cash.
The Federal Government regulates the minimum margin requirements for leveraged accounts. The Financial Industry Regulatory Authority (FINRA) presently stipulates a maintenance margin percentage of 25% of the total value of assets in a trader’s margin account.
Additionally, brokerage firms may also have different criteria, which are not always the same as those required by the government. Most brokerage firms have stricter requirements than the legal minimums to ensure financial stability for the firm. Margin maintenance requirements may vary depending on factors like volatility and market liquidity.
Maintenance Margin and Initial Margin
While these two terms are often used interchangeably, they are different things. For example, an initial margin account is required to open an account and buy any stocks or options. On the other hand, the maintenance margin is the amount you need to maintain in your account while trading. Since you can open an account with no initial margin and set up a stop-loss order, it doesn’t make sense to refer strictly to “initial margin” or “maintenance margin.”
How Maintenance Margin work
Maintenance margin is a somewhat obscure topic in the world of trading. However, we’re going to delve into it in great detail.
For example, if you want to buy 100 shares of a company at $20 each, but you don’t have enough in your account. You can buy stocks using margin accounts if you set up a percentage of the whole price as your initial investment. The first margin requirement is defined by the proportion of money invested at first.
So, what exactly is a maintenance margin requirement? It is the amount of money you must keep in your account to avoid being called for a margin call. Consider it this way: If the company’s stock has tumbled 30 percent, you must maintain a 40 percent maintenance margin.
As a stock’s price falls, the required margin ratio decreases. As a result, your total assets’ equity proportion decreases even more, when the cost drops.
Margin Trading Explained
Margin trading is quite risky yet an essential part of the maintenance margins. Below are a few things you need to learn about margin accounts.
Margin Account And Margin Contract:
First of all, you need to open a margin account to put your money. However, your broker may get your signatures before you open an account. These papers may talk about trading requirements, so don’t panic.
Make sure your broker doesn’t have conditions that don’t meet the country’s financial regulations regarding margin trading. Before signing, check the form carefully. If the regulations aren’t conventional, it’s a warning flag. Each brokerage will charge a different interest rate. Repayment terms and particular circumstances will be included in the contract. Once your account is opened, put a minimum margin account to initiate trading.
If you don’t have enough money to meet the maintenance margin, your broker will tell you that you need to put in more. This is what we call a margin call or more like a wakeup call that indicates that you may have to compensate if your account lacks funds.
After receiving a margin call, you must deposit additional funds and provide more collateral to balance the amount. Investors have been known to liquidate their investments in response to a margin call. For the most part, maintenance requirements for margins for most securities are lower. However, investors demand much higher maintenance margins when brokerage firms or exchanges face some concerns.
Why is Maintenance Margin Necessary
You must wonder if margin trading is a technique for brokers to get their money back. Well, that’s partially true. But there’s more to it than that.
You essentially borrow money from your broker to purchase securities when you trade with margin. This can be a risky proposition if the value of the securities falls.
By requiring a maintenance margin account, brokers can help to ensure that traders do not get in over their heads. If the value of your securities falls below the maintenance margin, you will receive a margin call from your broker. This allows you to add additional funds to your account or sell some of your securities to reduce your exposure.
Many traders who trade in margins suffer significant losses and gains. If these losses are not controlled, the market could be harmed. A snowball effect of gradual decline will occur if they aren’t regulated or watched. It will disrupt the stock market and cause panic among investors. Nobody wants that to happen. Not the traders, and certainly not the investors.
So, while the maintenance margin may seem like a hassle, it is a necessary safeguard to protect both parties in a margin transaction.
Advantages of Maintenance Margin
There are several advantages linked with margin accounts, and below are a few of those:
#1. Leveraging Assets
If you decide to trade with margin, you will have the opportunity to leverage your assets. This way, you can increase your total investment and earn a high ROI if the stock price rises. In addition, you can easily borrow up to 25 percent as declared by the Federal Reserve Board, and no other strategy allows you this facility.
#2. Short Selling
Margin trading also allows short selling so you can get quick profits from the declining price of a stock. For example, traders can purchase shares with the initial margin requirement and sell them on the market. Then, if the price falls, you can buy the same shares at a lower price and earn more profit. This way, you can maximize your returns on the original investment and increase your ROI.
#3. Low-Interest Rates
Margin trading also provides you with low-interest rates when you’re borrowing money. This is because brokers take a risk and charge interest to protect their money if the value of assets falls.
When the trader sells short, they will likely get a margin call. This happens when the value of securities in the margin account falls below a predetermined amount.
#4. Diversifying Portfolio
With a diverse portfolio, you can invest in many assets and earn the highest returns on investment. However, it is always a good strategy if your assets are highly concentrated in a single asset class or market. This is because the risk of losing everything when a single sector or class of assets performs poorly is very high.
#5. Participating In Advanced Options
Margin trading also allows you to participate in more advanced options strategies. These strategies (ETFs, index, butterflies, spread) can help you earn a high return on investment if executed properly.
Risks of Margin Trading
Margin trading is not without risks and may negatively impact your investment if you don’t understand its disadvantages.
#1. Failure To Meet Margin Calls
A margin call signals investors to deposit more money or sell some securities. Your account may be liquidated (sold) if you do not meet the call.
Failure to meet a margin call will force your account to liquidate. If your position is closed, you may lose money on the trade. Therefore, it’s important that you keep track of the margin balance in your account at all times.
#2. Leverage Risks
Leveraging your assets also increases the risk of losing money. The greater the leveraged trade is, the greater the potential for high losses. If your investment moves in the wrong direction and you don’t have the funds to meet margin calls, you will experience immediate losses and may be unable to recover.
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Conclusion: Maintenance Margin
A maintenance margin is essential to protect both parties in a margin transaction and to avoid market disruptions. It is also a good way to build a great relationship between a broker and the investor. The broker has confidence in the money’s safety. On the other hand, the investor is less concerned since the loss and gains are regulated.
Moreover, if you want to become a great investor, always be sure to do your research and use a reputable broker with a good track record. You can manage your maintenance margins and earn high profits without significant risks.
Maintenance Margin FAQs
Is it mandatory to have the margin requirements in cash?
Yes, the margin requirements must be met in full with cash. You can’t use securities as collateral for the margin requirement. Moreover, it can be further classified into initial margin and maintenance margin.
How long can I hold a margin loan?
The time you can hold a margin loan varies from broker to broker. The most important requirement is to pay interest on time. However, if you meet all the requirements, you can hold a margin as long as you want.