Margin and Margin Calls

What is margin? What is a margin call?

Margin is the amount of money or collateral deposited by a customer with his broker, by a broker with a clearing member, or by a clearing member with a clearing organization. (1) Initial margin is the amount of margin required by the broker when a futures position is opened; (2) Maintenance margin is an amount that must be maintained on deposit at all times. If the equity in a customer's account drops to or below the level of maintenance margin because of adverse price movement, the broker must issue a margin call to restore the customer's equity to the initial level. Exchanges specify levels of initial margin and maintenance margin for each futures contract, but Futures Commission Merchants may require their customers to post margin at higher levels than those specified by the exchange. Futures margin is determined by the SPAN margining system, which takes into account all positions in a customer's portfolio. (Source: CFTC)

"Margin" is borrowing money from your broker to buy a stock and using your investment as collateral. Investors generally use margin to increase their purchasing power so that they can own more stock without fully paying for it. But margin exposes investors to the potential for higher losses.

Let's say you buy a stock for $50 and the price of the stock rises to $75. If you bought the stock in a cash account and paid for it in full, you'll earn a 50 percent return on your investment. But if you bought the stock on margin – paying $25 in cash and borrowing $25 from your broker – you'll earn a 100 percent return on the money you invested. Of course, you'll still owe your firm $25 plus interest.

The downside to using margin is that if the stock price decreases, substantial losses can mount quickly. For example, let's say the stock you bought for $50 falls to $25. If you fully paid for the stock, you'll lose 50 percent of your money. But if you bought on margin, you'll lose 100 percent, and you still must come up with the interest you owe on the loan.

In volatile markets, investors who put up an initial margin payment for a stock may, from time to time, be required to provide additional cash if the price of the stock falls. Some investors have been shocked to find out that the brokerage firm has the right to sell their securities that were bought on margin – without any notification and potentially at a substantial loss to the investor. If your broker sells your stock after the price has plummeted, then you've lost out on the chance to recoup your losses if the market bounces back. (Source: SEC)

In finance, a margin is collateral that the holder of a position in securities, options, or futures contracts has to deposit to cover the credit risk of his counterparty. This risk can arise if the holder has done any of the following:

• borrowed cash from the counterparty to buy securities or options,
• sold securities or options short, or
• entered into a futures contract.

The collateral can be in the form of cash or securities, and it is deposited in a margin account. On U.S. futures exchanges, margin is formally called performance bond.

Margin buying is buying securities with some of one's own cash together with cash borrowed from a broker. This has the effect of magnifying any profit or loss made on the securities. The securities serve as collateral for the loan. The net value, i.e. the difference between the value of the securities and the loan, is initially equal to the own cash used. This difference has to stay above a minimum margin requirement. This is to protect the broker against a fall in the value of the securities to the point that they no longer cover the loan. (Source: Wikipedia)

Margin Calls

A margin call is (1) A request from a brokerage firm to a customer to bring margin deposits up to initial levels; (2) a request by the clearing organization to a clearing member to make a deposit of original margin, or a daily or intra-day variation margin payment because of adverse price movement, based on positions carried by the clearing member. (Source: CFTC)

When the margin posted in the margin account is below the minimum margin requirement, the broker or exchange issues a margin call. The investor now either has to increase the margin that he has deposited, or he can close out his position. He can do this by selling the securities, options or futures if he is long and by buying them back if he is short. (Source: Wikipedia)

Leverage

What is leverage?

Leverage is the ability to control large dollar amounts of a commodity or security with a comparatively small amount of capital. (Source: CFTC)

Leverage (or gearing) is using given resources in such a way that the potential positive or negative outcome is magnified. In finance, this generally refers to borrowing. If the firm's return on assets (ROA) is higher than the interest on the loan, then its return on equity (ROE) will be higher than if it did not borrow. On the other hand, if the firm's ROA is lower than the interest rate, then its ROE will be lower than if it did not borrow.

Financial leverage takes the form of a loan or other borrowings, the proceeds of which are reinvested with the intent to earn a greater rate of return than the cost of interest. Leverage allows greater potential return to the investor than otherwise would have been available. The potential for loss is greater because if the investment becomes worthless, not only is that money lost, but the loan still needs to be repaid. Margin buying is a common way of utilizing the concept of leverage in investing. An unlevered firm can be seen as an all equity firm, whereas a levered firm is made up of ownership equity and debt. A firm's debt to equity ratio (measured at market value, not book value) is therefore an indication of its leverage. Degree of financial leverage (DFL) may be defined as the percentage change in earnings (EPS) that occurs as a result of a percentage change in earnings before interest and taxes. (Source: Wikipedia)

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