For some experienced traders, pursuing goals in the market is largely about finding opportunities to gain leverage. Traditionally, a trader's available assets may limit their ability to buy securities. But when approved for a margin account, a trader can potentially borrow money from their broker.
Margin gives traders more money to put to work, which increases their potential return. Of course, having borrowed money on the line also increases risk through increased leverage and strict time frames for meeting account deficiencies.
Traders must repay margin loans whether the trade works out or not. If the trader cannot repay the loan, the brokerage firm is on the hook. If there's a market crisis, a domino effect of insolvent traders could lead to brokerage firms failing (it happened in the Great Crash of 1929) and damage to the entire financial system.
To avoid a cataclysmic event like this, brokerage firms are required by the Federal Reserve Bank to limit margin loans to 50% of a customer's account. This is the initial margin. After that as the market moves up and down and changes the position's value, brokerage firms may set limits on how much margin clients must maintain based on FINRA regulations and each firm's risk management system. If a client's account value falls below the minimum amount of maintenance margin required, the broker will issue a margin call and ask the client to deposit more cash and securities, or the client will face unwanted sales of positions and maybe even account liquidation.
Schwab uses a risk-based concentration (RBC) model, also known as intraday concentration, to determine the required amount of maintenance margin. This is calculated by considering the amount of risk in an account's individual positions, rather than setting an absolute percentage cutoff.
Schwab's absolute minimum is a 30% maintenance margin, but Schwab may apply higher base requirements to certain securities for various reasons.
Understanding maintenance margin
In reality, many trades move against the trader—at least at first—and if that happens, the account's equity may change and require the trader to take action.
For example, let's say a trader places a trade worth $1,000 on margin, using $500 in cash and borrowing $500. This trade has a 50% equity at the outset. If the value of the trade falls to $714, the trader now has just $214 in value to support the $500 in borrowing, or a 30% equity. If the trade value falls below $714, the trader must deposit funds as cash and/or securities—or liquidate some of their position—or they risk having the trade closed and the account liquidated.
Calculating RBC
To determine if maintenance margin should be higher than the minimum house maintenance requirement for the security a trader is going to trade, Schwab runs an RBC calculation based on two figures.
The calculation starts by estimating an Expected Price Range (EPR) for each security in the trading universe. Not a predictor of price movement, the EPR is the theoretical maximum amount a security could move up or down in a single day in response to external factors. The EPR is determined by criteria including volatility, historical data, liquidity, and other factors.
Schwab also conducts an additional calculation on each position in a trader's account to determine that security's Point of No Return (PNR), which is the percentage move a security would have to make before the trader's entire account goes to zero. Anyone who's watched the market regularly knows that when an asset's value moves rapidly and dramatically lower, there's often a fundamental problem that will keep it from recovering its value quickly.
The PNR is calculated by looking at each individual position and comparing that to the overall account value. Schwab then looks to see how far that position must move before the overall account goes negative. If a stock's PNR number falls within the boundaries of its EPR—meaning its percentage change before the account goes negative is within the confines of its theoretical maximum daily move—there is more risk that the account could go in the red. This risk exposure will lead to the maintenance requirement being held at the EPR percentage. This adjustment can lead to a significant change to available funds and create a margin call that's due immediately.
If the PNR is outside of the EPR, the account risk is outside of Schwab's risk parameters, so the margin requirement would likely be held at the lowest requirement for that position. This level may still be higher than the minimum 30%, depending on special margin conditions.
If the PNR is inside the EPR but then moves back outside the EPR confines, the margin requirement—and the account's buying power—will reflect the new reduced requirements. Note that it may take up to 30 minutes during normal market hours for the margin requirement and buying power levels to adjust and reflect the newly reduced requirements.
An RBC example
- Account value: $20,000
- Margin amount: $20,000
- Total holding of ZYX stock: $40,000
- ZYX EPR: 50%
With this combination of account value and EPR, the PNR will be equal to the EPR; if ZYX were to decline 50%, the account value would lose $20,000, dropping its value to $0.
If, on the other hand, the trader held $45,000 worth of stock, a 50% drop in ZYX would result in a loss of $22,500 and a negative account balance of $2,500. Because the PNR is inside the EPR in this scenario, the margin requirement on the position would be held at 50%, or in this case, $22,500.
Bottom line
Used thoughtfully, margin can increase a trader's potential return, but it also increases risk and is not suitable for all investors. Not only does the margin trader take on risk, but so do Charles Schwab and the entire financial system. That's why the Federal Reserve regulates initial margin and FINRA requires member firms to have risk-based metrics for setting maintenance margin.
While Schwab uses RBC to determine if a position's maintenance margin should be higher than the base requirement, RBC isn't the only metric at play. Traders may have to increase margin or reduce position size for other reasons, so those employing margin need to keep a close eye on their account regularly to avoid an unwanted margin call.
How do margin loans work at Schwab?
This material is intended for general informational and educational purposes only. This should not be considered an individualized recommendation or personalized investment advice. The investment products and investment strategies mentioned may not be suitable for everyone. Each investor needs to review an investment strategy for his or her own particular situation before making any investment decisions.
All expressions of opinion are subject to change without notice in reaction to shifting market, economic or political conditions. Data contained herein from third party providers is obtained from what are considered reliable sources. However, its accuracy, completeness or reliability cannot be guaranteed.
For illustrative purpose(s) only. Individual situations will vary. Not intended to be reflective of results you can expect to achieve
Investing involves risk, including loss of principal, and for some products and strategies, loss of more than your initial investment.
When considering a margin loan, you should determine how the use of margin fits your own investment philosophy. Because of the risks involved, it is important that you fully understand the rules and requirements involved in trading securities on margin.
Margin trading increases your level of market risk.
Your downside is not limited to the collateral value in your margin account.
Schwab may initiate the sale of any securities in your account, without contacting you, to meet a margin call.
Schwab may increase its "house" maintenance margin requirements at any time and is not required to provide you with advance written notice.
You are not entitled to an extension of time on a margin call.