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Limitations on Margin Trading

Limitations on Margin Trading

Margin trading in securities is the use of borrowed funds to pay in part for the purchase of the securities. Margin trading is regulated by the Federal Reserve Board and by self-regulatory organizations such as the New York and American Stock Exchanges and NASDAQ. While margin trading allows an investor to increase the leverage of the investor’s funds by adding borrowed funds and thereby increase the size of the purchase of securities, the increased leverage requires the assumption of greater risk by the investor. Regulation of margin trading is designed to limit the amount of additional risk that the investor may assume.

 

When an investor buys securities on margin, securities in the investor’s account serve as collateral for the portion of the purchase price that is loaned to the investor. While the investor must also pay interest on the borrowed portion of the purchase price, a decline in the value of the collateral may allow the investor’s broker who loaned the borrowed portion to make a margin call. A margin call may simply be a requirement for an additional deposit of funds with the broker to support the collateralized value of the securities. However, as the risk of downward movements in the securities increases, the following risks also increase:

 

  • The broker may sell any securities in the investor’s account without contacting the investor;
  • The broker may increase margin requirements at any time and without advance notice;
  • The broker need not grant an extension of time to an investor to meet a margin call; and
  • The investor’s risk may extend beyond the total amount of the assets in the investor’s account if those assets are insufficient to meet a margin call.

Limits on margin accounts set by the Federal Reserve Board and the exchanges and NASDAQ include minimum margins, initial margins, and maintenance margins. These limits must be followed by brokerage firms although brokerage firms may establish greater limitations on margin trading if they wish.

A minimum margin is a cash amount that must be on deposit with the brokerage firm before any purchase of securities is allowed with less than 100 percent of the purchase price paid by the investor.

The initial margin is set by Regulation T of the Federal Reserve Board. While fifty percent of the purchase price has been the limit on the amount of margin allowed an investor when initially purchasing securities, that percentage may vary according to the Federal Reserve Board’s view of market conditions.

The maintenance margin is the minimum amount of equity that an investor must maintain in a margin account. That value is the ratio of the value of the securities in the account to the amount of money owed to the brokerage firm. The maintenance margin set by rules is 25 percent, although brokerages may set higher percentages depending on market conditions and the quality of the securities held in the margin account.

Copyright 2012 LexisNexis, a division of Reed Elsevier Inc.

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