Lesson Objective: Understanding the concept of margin requirements and margin calls.
Margin Requirements and Margin Calls for Stocks/ETFs
Contrary to equities and futures where margin is used as leverage to increase buying power, option margin is used as collateral to secure a position.
An investor (or trader) is said to buy a security (equity) on margin when he pays only a portion of the acquisition cost (the “collateral”) while the rest is financed by his brokerage firm through a loan (an interest charge is paid monthly to the account based on the borrowed amount). Stocks that can be bought on margin are called “marginable equity”.
The collateral required at inception is called the initial margin requirement while the collateral required subsequently (until the position is closed) is called the maintenance margin requirement (or minimum maintenance), which is generally lower than the initial margin requirement. The maintenance margin requirement typically changes over time as market conditions fluctuate. Both requirements depend on the type of trade/security, regulatory rules, and the brokerage firm’s own policy regarding margin. According to Regulation T of the Federal Reserve, the initial margin requirement for equity is 50% while the maintenance margin requirement is 25% (note however, that a higher collateral may be required for certain securities and most brokerage firms require a maintenance margin requirement of 30%).
For instance, let’s assume that the investor wants to buy stock XYZ – currently trading at $100 – on margin. The brokerage firm would typically ask that he puts at least 50% down (i.e., a 50% initial margin requirement). In other words, the investor could acquire one XYZ share by paying only $50 in cash now and borrowing the other $50 from the broker. This also means that under Regulation T one could invest in eligible securities up to twice as much as the cash held in the brokerage account. This is called the “buying power”.
So, if the investor’s brokerage account has $10,500 in cash, he could buy up to $21,000 (market value) of eligible equities, which would be his total buying power. Note that he would have to pay interest on the $10,500 borrowed from the broker. If the investor’s collateral falls below 30% then the broker will issue a margin call, which is an immediate request for the investor to contribute additional funds into the portfolio so that a 30% collateral threshold is met again.
In the example above, the investor has bought $21,000 worth of various equities using $10,500 in cash and $10,500 as a loan from the broker. A 30% margin means that the investor’s net share in the portfolio’s market value (i.e., after deducting the $10,500 loan owed) must represent at least 30% of the total market value of the portfolio at all times, so this would set the threshold for a margin call at $15,000 [loan of $10,500/(100%-30%)]. If the value of the portfolio drops to $15,000, then the investor’s net share in the portfolio’s market value drops from $10,500 (cash initially invested) to $4,500 ($15,000 – $10,500 outstanding loan), remember that the investor stills owes $10,500 to his broker. The $4,500 represents 30% of the total market value of the portfolio ($15,000).
Any portfolio value under $15,000 would trigger a margin call. For instance, if the portfolio’s value further declined to $12,000, then the investor would have to contribute $3,000 in cash to maintain the maintenance margin requirement of 30%.
The investor could also decide to provide additional collateral in the form of securities or sell some of his securities instead of contributing more cash in order to maintain the maintenance margin requirement. If the investor fails to bring the account back into line, the broker can sell the investor’s collateral securities without asking for the investor’s prior consent as to which securities to dispose of.
The benefit of buying on margin is that the return on investment can be greater if the equity or portfolio appreciates in value. However, this is a double-edged sword. The leverage effect of a margin purchase also applies to losses.
Let’s go back to the example above where you purchase $21,000 worth of marginable securities with $10,500 of your money and a $10,500 margin loan from your broker. Assume you purchase 100 shares of stock XYZ at $210 per share and decide to sell them later when XYZ is at $315. You receive proceeds of $31,500 and pay back the $10,500 loan, so you are left with $21,000 in your pocket. That’s a net profit of $10,500, a 100% profit on your original investment of $10,500. Had you instead used solely your own money to purchase $10,500 worth of XYZ (50 shares), you would have received proceeds of $15,750 at the time of the sale, representing only a $5,250 (50%) profit.
Now, instead of XYZ rising, let’s assume that XYZ goes down 50% to $105 at the time you need to sell it and you had bought it on margin in the same fashion as above. The proceeds would be $10,500, all of which would be used to repay the $10,500 loan from your brokerage firm. In other words, you would be left with no money and would have lost $10,500 i.e., 100% of your investment. Had you instead used only your own money and purchased $10,500 worth of XYZ (50 shares), you would have received proceeds of $5,250 at the time of the sale, representing only a $5,250 (50%) loss.
As you can see, buying on margin amplifies the potential profit or loss, hence the concept of a double-edged sword that must be used cautiously.
Margin Requirements and Margin Calls in Options
Anyone who is looking to trade options must first request approval from their broker. Brokers typically classify options trading clearance levels depending on the type of strategies employed. Buying options is usually a Level I clearance because it does not require margin. However, writing naked puts may require Level II clearances and higher margin requirements. Level III and IV accounts often have lower margin requirements because they are typically granted to more experienced traders that will be using defined-risk strategies.
Option margin requirements are complex and differ substantially from equity margin requirements. Option margin is not used for leverage but rather as collateral to secure an option position. Such margin depends on the option strategy used (some option strategies, such as covered calls and covered puts, have no margin requirement since the underlying is used as collateral), the underlying, market conditions, regulatory rules (Regulation T and the Federal Reserve Board), and the brokerage firm’s own internal policy regarding margin requirements.
For instance, TD Ameritrade mentions (at the time of this writing) that:
Buyers of long options must pay 100% of the purchase price. Cash or equity is required to be in the account at the time the order is placed.
Sellers are exposed to a greater risk of loss; therefore, the margin requirements are higher. The writing of naked puts and calls requires an initial deposit and maintenance of the greatest of the following three formulas:
a) 20% of the underlying stock less the out-of-the-money amount, if any, plus 100% of the current market value of the option(s).
b) For calls, 10% of the market value of the underlying stock PLUS the premium value. For puts, 10% of the exercise value of the underlying stock PLUS the premium value.
or
c) $50 per contract plus 100% of the premium.
The outcome of these formulas could signify a margin call under which you would be required to close some positions, add more collateral, or contribute additional cash into your brokerage account in order to avoid any forced action by the brokerage firm on your behalf but without your input.
Therefore, it is essential that you check the initial and maintenance margin requirements with your broker before entering into an option trade so that you are clear on the conditions under which you could be subject to a margin call. Option margin requirements can have a significant impact on the profitability of a trade since it ties up capital.
Finally, margin requirements are also used in some option strategies to calculate their risk/reward profile, in particular when the risk of the trade is undefined. We will discuss this concept in more detail in our next lesson.