When you trade with a broker or a counterparty, you do not invest everything that you have at once. You are required to keep a certain sum with them that would be enough to cover the credit risk pertaining to your account. This sum is called the maintenance margin. This margin works like collateral and could be anything with a value like securities or cash. This amount is a security that could be used as a guarantee for the credit risks that could happen due to a number of reasons like losing on a leveraged position, being part of a derivatives contract, or maybe selling securities short. This amount lets the broker know that you have enough funds that you can invest further while trading.
In simple terms, it is the minimum balance or equity that the trader maintains in a separate account once he or she has made a purchase. This minimum collateral needs to be held at the same level as long as the trader is holding any position.
The maintenance margin is the minimum amount of equity in the trading portfolio that a trader or investor must maintain in the margin account after the purchase of assets has been made. Usually, a maintenance margin is 25% of the securities’ total value in a margin account as per FINRA requirements.
Maintenance margin formula
The maintenance margin in dollars is equal to the amount of money per borrowed share divided by the maximum allowable percentage of borrowed funds.
For example, if the asset price is $10 and 50% is the margin requirement then 10x (1-0.50)=$5. Money per borrowed share is $5. If the maintenance margin is 25% then the maximum allowable percentage for borrowed funds will be (1-0.25)=0.75, or 75%. The amount of money per share borrowed $5, divided by the maximum allowable percentage of borrowed funds 0.75 is equal to $6.67 which is the maintenance margin.
Money per borrowed share= Asset price x (1-Margin requirement (%)
Maintenance margin($)= Money per borrowed share/(1-Maintenance margin)
Why do We Need Margin Accounts?
The main purpose of the maintenance margin is to act as collateral that traders might use to borrow money from the exchange or their broker. But why would traders borrow money from the exchange or their brokers? Let us tell you why.
A bigger investment in the market fetches bigger profits. $5000 will fetch you more gains than $100 but in reality, not every trader is comfortable in investing a large sum. If they are certain about their strategies, they can trade on leverage. Leverage allows you to operate a larger amount in the market than your actual investment. Brokers allow different ratios of leverages. If your broker is offering leverage of 1:50, you would be able to operate $50 for every $1 that you invest. In this way, if you invest $100, you will be operating $5000 in the market. Similarly, your gains will also be magnified 50 times.
Well, this is a utopian example because trading on leverage can magnify losses as well. To protect themselves from being taken advantage of, brokers ask investors to maintain minimum equity. This is a risky business. Governing authorities are often very strict about purchasing securities using margin. Maintaining a margin is one such rule that counters the risk of duping the investor and is to be maintained until the position is closed and all the dues are cleared.
Regulatory bodies like the Financial Conduct Authority (FCA) and the Financial Industry Regulatory Authority (FINRA) keep a check on the margin because trading on leverage can land both trader and broker in a pool of debt. While brokerages can set modes of repayment and interest rate as they fit, they are required to follow every norm and guideline related to maintenance margin. It is mandatory for them to get a margin agreement signed by traders and investors before they begin trading. This agreement only becomes active once securities are bought using this minimum equity.
The minimum maintenance margin is set at 25% by NYSE and FINRA. Brokerage firms can extend it to up to 40%, depending on their policies.
What is Maintenance Margin in Forex?
Traders are required to follow the maintenance margin even when they are trading currency pairs. The leverage limit or the margin ratio is decided by brokerage firms because Forex trading happens across countries and they all have different regulatory bodies and rules. Typically, it remains between 25% – 40%.
Let’s see how trading on leverage works in Forex trading. Let us suppose you purchase 200 units of a currency pair like the GBP/USD pair at US$1.3041 and the margin provided by the broker is 4:1. In this situation, the equity of the transaction would be 1.3041/4. This is equivalent to US$0.3260. It is the equity that was pitched in by the trader. The rest of the funds required will be compensated by the broker. Even in this case, the trader is still obligated to maintain minimum equity.
If due to any reason, the funds are less than the maintenance margin fixed by the broker, the trader will be immediately asked to compensate for the difference. Your broker might even go ahead and sell some holdings from the account in order to reimburse the lost balance. These holdings are sold at the current value. If the current value is less than the value that you paid while buying that asset, you will be the one bearing the loss. This makes it imperative to maintain your mi9nimum equity at all times because the brokers don’t need your permission before selling your holdings.
Difference between Initial Margin and Maintenance Margin
It is not uncommon for a new trader to get perplexed by the trading terms, especially when they are closely linked. The maintenance margin and the initial margin can leave a novice trader wondering. These two are completely different yet closely related. The initial margin is the minimum margin that the trader is supposed to have while purchasing security. The regulatory bodies of the US have fixed it at 50%. This means that if you wish to buy 400 shares at $5/share, making a total of $2000. The US Federal Reserve Regulation T will allow the broker to fund 50% of this amount, i.e., $1000.
A brokerage firm can ask you to deposit an even higher initial margin because 50% is the minimum requirement set by the Fed. There is no upper limit. In some cases, the broker might ask you to pay $1500 and they keep their deposit of $500. The maintenance margin will be activated once you have purchased all 400 shares. The broker will ask you to maintain this minimum equity till you close your position and clear all the dues.
The maintenance margin acts as a protective shield for the brokers since they are lending money to their customers.