Taking out loans from a broker to expand market order capabilities is the essence of margin trading, with the aim of maximising anticipated returns. Nonetheless, there is a possibility of negative outcomes if the market underperforms, causing the trader to be financially deficient. In order to keep a leveraged trading position, a trader needs to deposit a certain sum of money as a variation margin. Brokers employ free margins to give investors confidence in their ability to settle debts, thus decreasing the likelihood of default.
What Is A Margin Account?
Let’s start with an instance.
A trader, anticipating an increase in Google’s stock price, plans to purchase 100 shares at $200 each, but with only $1,000 in their account, the market order will cost at least $20,000.
This is possible with a margin account.
Purchasing assets with borrowed funds involves utilising a broker’s assistance and funds to engage in risky market investments. It’s commonly used by traders with little money to exploit market chances.
With a collateralised account, traders can get 1:20 leverage, multiplying your 1,000 balance by 20 and allowing you to execute market orders at 20,000 USD.
What Is Maintenance Margin?
Margin trading necessitates a maintenance margin (also called variable or free) representing the lowest portion of assets a trader must have in their portfolio in order to meet margin prerequisites.
The government regulates the least possible margin demands for leveraged accounts, with FINRA setting at 25% of the all-around value of securities held in a trader’s margining account. Brokerages may also have their own restrictions, often higher than the government’s, to provide greater financial security.
Margin maintenance prerequisites vary based on market liquidity and volatility, with different stocks having varying terms with higher demands for volatile stocks.
In other words, to open an account trading on margin, a trader must have a variable margin, necessitating a minimum portion of their equity to be held as collateral by the broker. The calculation varies for each market order and is determined by the broker’s system and regulations. Margin demonstrates the remaining funds before a margin call is triggered.
Leveraged trading involves maintaining a variable margin based on leverage, traded volume, capital, and broker rules. Once the balance reaches maintenance, the broker issues a margin call, conceivably leading to account closure or asset disposal to avert outsized losses. Beginner traders should be particularly cautious before trying this strategy due to the many risks involved.
Let’s look at the example of a free margining.
If you want to trade 100 shares of ABC at $500, your full position value is $50,000. However, you only need to deposit 20%, resulting in a leveraged deposition of $10,000 ($50,000 x 20%).
If your account falls due to your position losing capital, you will be placed on a margin call immediately. To retain your position open, you must top up the account to hold your balance above $10,000.
The payment you would be mandated to credit is your free margin. If your balance falls to $9800, you need to add $200 to your account. If your account’s capital falls by 50% to $5000, your account will be triggered for position closure.
What Is a Margin Call
A margin call arises when a leveraged trade’s worth reaches the free margin portion, requiring investors to allocate funds to the account before liquidating the position. Brokers can sell securities without consulting clients, and under most margin agreements, companies can sell securities without waiting for responses.
Let’s take an example.
A trader with $100,000 in stock in their collateralised account must hold a minimum of $25,000. An increase in equity price to $150,000 increments the free margin to $30,750. A margin call is issued in case the shares’ value falls below the margin level.
Margin Call Calculation
The following formula is used to calculate a margin call:
Margin Call Price = P0 (1 – initial margin / 1 – free margin),
with P0 being the initial buying price.
Variable Margin Formulas
There are two approaches to calculating maintenance margin.
- Variation Margin Level = (Position Amount * Average Entry Price * Variation Margin Rate) + Assumed Commission for Closing the Position
- Average Position Price = Total Contract Value / Total Transaction Amount.
Engaging in trading using money loaned from a broker comes with various risks, conceivably leading to owing money to brokers and incurring losses. Trading with collateral budgets is well-suited for those who are willing to take on risk and have a large sum to invest. Free margin serves as a risk evaluation tool, providing insight into the probable market direction and trade risk. Thus, it’s crucial to calculate and analyse the situation carefully before making any trades.