LEVEL: INTERMEDIATE
The more money you have, the more money you make. This is especially true for investing, but investors can find that there are ways beyond simply stockpiling money to enhance their returns. Brokers have created a sophisticated process in which investors can borrow capital that is used to invest in stocks and futures to enhance their returns. Called margin, this allows investors to borrow capital using the securities they hold within their account as collateral. Margin provides leverage, which can enhance and detracted from returns.
Margin Defined
A margin account will allow an investor to borrow money to invest with, while the investor’s collateral is a deposit that covers some or all of the credit risk of their counterparty. Margin is most often associated with a broker or an exchange. The collateral that can be used to post margin can be in the form of cash or securities, and it is deposited in a margin account. On United States futures exchanges, margin was formerly called a performance bond. Most of the exchanges today use the SPAN (Standard Portfolio Analysis of Risk) methodology to calculate the margin used to invest in options and futures. SPAN was developed by the Chicago Mercantile Exchange in 1988.
Initial Margin
Initial margin, for both equity and futures accounts, is an amount of capital that is needed to be deposited in order for a trade to be executed. Once a trade is transacted on a security, a margin account is monitored in an effort to insure there is enough capital in an account to cover any loses that might incur on a position. This initial margin is to be paid no matter whether you are the long or the short in this new position. Generally, Initial Margin is the minimum required value in an account necessary to open a position on a futures contract.
According to Regulation T of the Federal Reserve Board, the initial margin on stocks is currently 50%. This level is only a minimum and some brokerages require that investors deposit more than 50%.
The goal of SPAN risk array that is used for margin accounts is to attempt to lower the amount of capital that needs to be deposited. The system will in some respects give credit to offsetting positions, where a trader is long one position and short another correlated position.
The initial margin is a kind of guarantee that you have the money to pay for your losses should losses occur the very first day that the equity or futures position is initiated. For instance, if you bought 1 contract of oil futures, you would be prompted for a Futures Requirement of $6,000 (for a contract size of 1000 barrels per contract). The whole margin system is a mechanism to make sure parties involved have sufficient cash to cover losses in order to lower the clearinghouse’s risk of guaranteeing performance.
Maintenance Margin
Generally, the “Maintenance Margin” is the amount of money an investor must maintain in his or her account to keep an open position on a futures contract. Should the value of the investor’s account fall below the maintenance margin, his or her brokerage will issue a margin call.
A margin call is the broker’s requirement for additional capital to make a loan whole. If unrealized losses incur that are above the level of collateral held on deposit by the broker, the investor will need to add the required capital to satisfy their debt.
Margin Risk
Margin risk is related to the ability of a portfolio manager to hold positions based on a potential margin call or lack of collateral. If a portfolio manager receives a margin call, he will be prompted to post collateral to the account within a specific time frame. If collateral is not posted, the position will be liquidated without consulting the portfolio manager.
The risk here is obvious. If a position is liquidated unilaterally by a broker, a portfolio manager can sustain significant losses especially in the case of a large adverse move on a specific position.
Leverage
A margin trade creates leverage or gearing for an investor which can enhance or detract from the returns of a portfolio. For example, if an investor purchases 1 share of stock XYZ for $50 dollars and it increases to $60 dollars the investor makes 20 percent on their trade. If on the other hand, the investor uses margin to purchase the stock and only uses $25 dollars to purchase a $50 dollar stock, then a $10 dollar increase (from $50 to $60) would generate a return of 40 percent ($10 divided by $25). With a margin account the investor would need to pay an interest rate on the borrowed capital which detracts from the returns. If the interest rate was 5%, and the trade was held for 1 year, then $1.25 would need to be subtracted from the returns (5% of $25).
The benefit here is equally obvious. While investing on the margin, you can get more gross income from investing either in the form of dividends or capital gains, although your total yield on cost is lower than if you had invested with 100% your own cash instead of borrowing to further the investment. This is how some funds earn a profit of 10% by investing in bonds that yield less than 10%, for example.
Portfolio Margining
This type of margining views all of the securities within an account when determining margin. In this case, if a portfolio manager has offsetting positions, such as a long security position vs. a short in another security, the manager will not be punished for losses due to only one security. If fact, gains on one security will offset losses in another security.
For example, if a portfolio manager has a long heating oil position against a short crude oil position, a downward movement in petroleum will create losses in heating oil that might generate a margin call. These losses will be offset by gains in crude oil, which will mitigate the need to post additional collateral. If the heating oil position was liquidated by the broker, the portfolio manager would then be subject to an upward move in petroleum which could create losses on the crude oil position.
Margin positions come with significant risks, and it is very important for a portfolio manager to have a robust understanding of how margining works with their account prior to transacting with a specific brokerage.