Before we begin with different types of margins, let us look back at what margin trading is. Suppose I is an investor and B is a Broker. I is extremely sure of an investment strategy that he has developed. But due to the limited capital, his gains are limited. So, he goes to his broker B and says that I have 10$ but I would like to invest worth 100$. Would you like to provide me with the remaining 90? B says, that he is willing to provide the same but he would charge some extra commission for that. A agrees and pays the 10$ , B gives him the remaining 90 and A then invests the 100$. He makes a profit and then returns the 90 plus the extra commission to B. The transaction above in layman terms is margin trading.
So in simple terms, Margin Trading is a way to magnify the buying power of the investor by borrowing the capital from the broker.
Now you maybe wondering what’s margin in this case. Margin account has to be maintained with the broker. This account is different from the regular cash accounts that are used for trading. The investor needs to post a certain amount in the account before he can start trading on margin.
Let’s have a look at how these amounts are classified:
Initial Margin: Before you start trading on margin , you have to deposit a certain amount in your margin account. That amount is known as the Initial Margin. According to the Federal Reserve’s Reg T, this amount is 50% of the amount that the investor is borrowing from the broker. The regulation sets only the minimum bar. However, your broker may charge you or ask you to post Initial Margin amounting to greater than 50%.
So, suppose you decided to start margin trading and want to buy Apple shares worth 1000$. Therefore, you will have to deposit 500$ in your margin account. So everytime, you need to trade on margin, you need to deposit the initial margin. But the initial margin is based on the purchase price and thus remains fixed irrespective of market volatility. E.g. IF a stock costs 10$, 5$ is the initial margin requirement and it will remain fixed irrespective of what the market price is.
Maintenance Margin: It is also known as maintenance requirement. It is the minimum amount that must be present in the margin account of an investor. According to the Reg T, this amount is 25% of the total value of securities which are bought via the margin trading account. Considering the same Apple example as mentioned above. 1000$ is the total investment and 500$ is the total Initial Margin posted by the Investor.
Now, suppose that the value of the investment falls to 600$. Remember, the borrowed amount is still 500$. That means the investor’s own funds has gone down to 100$.
According to the maintenance margin requirements, the amount in the margin account should be 25% of the total security value. Here the value is 600$, so the maintenance requirement is 150$. But as calculated above, the investor’s own funds only amounts to 100$, the remaining 500$ being borrowed from the broker. So the investor will have to deposit additional 50$ to meet the maintenance requirement.
This is known as margin call i.e. when the broker informs the investor to infuse more capital into the margin account to achieve the minimum required maintenance margin.
Variation Margin: The variation margin is the difference between the margin requirements between two successive days. It is measure as MTM value which is the abbreviated form of Mark to market. It implies that the most recent market price of the security has been taken into consideration to calculate the margin requirements. Suppose the margin requirement is 100$ for Day T-1 and it is 120$ for Day T. Thus, the variation margin is 20$. Variation margins are useful for daily settlements of contracts.
Suppose the client has posted a collateral to fulfill the margin obligations. The margin requirements are 100$ and he/she posts a collateral worth 100$. Now, the bank will constantly monitor the collateral’s market value. Suppose the market value is 120$, which results in a variation margin of +20$ and results in a condition where the client is fulfilling the margin obligations. In another case, consider that the value of the collateral according to current market price is 80$ which leads to a variation margin of ‘-20$’ and thus in this case, the client is unable to fulfill the original margin requirement of 100$ and thus will be served with a margin call.
Thus, these are the different types of margins and basics of margin trading.
We will talk about collateral management in the next blog post.