Margin trading has equal chances of easily spiking both, huge profits or equally huge losses. One way to prevent this is by keeping tabs on your maintenance margin levels.
Margin Funding: A quick walk-through
Margin funding is a short-term loan that you borrow from your brokerage to invest in a large volume of shares for a relatively small investment amount. To avail this facility, you must first open a margin account with your brokerage, using either cash or marginable securities available in your portfolio. There is an interest charged every time you use this facility, followed by a minimum threshold of securities that you must always maintain in your margin account. This threshold is also known as the maintenance margin.
In order to trade using margin funding, you must first open a margin account. The process to open a margin account begins when your brokerage firm drafts a margin agreement for you to agree and sign. The margin agreement that is drafted must comply to the minimum requirements set by the market governing authority, however, each brokerage firm has their own set of terms and conditions included within the agreement, such as interest rates and repayment policy. Common for all brokerage firms is that securities and positions purchased using margin funding are considered collateral.
Once you sign the margin agreement, an initial margin is payable to activate your account in the form of either cash or through marginable securities. Generally, you can borrow up to 50% of the value of the security that you wish to purchase. However, some brokerage firms require a percentage above 50% to be deposited from your end towards the transaction, as specified in your agreement.
The maintenance margin kicks in when you make your first purchase from your margin account. The thumb-rule is that you maintain a minimum 25% of the total market value of your purchased securities in your margin account at all times. Again, it is important that you clear the terms of this percentage as some brokers require a higher amount value to be maintained in the account.
Should you encounter a loss on the market, where equity falls below the maintenance margin in your account, then the brokerage initiates a margin call. This will require you to either deposit more cash into your margin account to level out the maintenance margin fund shortfall in your margin account, or sell securities to ensure that the maintenance amount is repaid and the margin maintained. Your brokerage firm reserves the right to sell the securities in your account if you fail to repay the amount within the given window. As per the signed agreement, your brokerage may even take this call without prior consultation, in order to bring back the level of maintenance margin required. Any access returns from the sale is then credited to your account.
Maintenance margin exists to regulate risks associated with margin funding, like overtrading and fraud. While there is huge potential for gains in margin trading, equal chances of loss pose a financial risk that can not only unsettle the securities markets, but also potentially disrupt the financial market as a whole.
Margin trading requires extensive market knowledge and it is recommended that you seek financial assistance when using borrowed funds to invest in the market from our expert financial advisors.