Leverage and Margin Explained: How Margin Calls Work

The CFTC defines leverage as “the ability to control large dollar amounts of a commodity or security with a comparatively small amount of capital.”

It can be created in more than one way. The SEC names three: borrowing money on margin, using options, and buying securities that are themselves leveraged, such as leveraged ETFs.

Whatever the route, the effect is the same. Every move in the price counts for more, against the account as much as for it.

The word margin means different things in different markets, and the difference matters:

• In a stock account: the broker-dealer lends the investor cash to buy securities, using the account as collateral. Margin here is a loan, and like all loans it charges interest.
• In a futures account: margin is money deposited as a performance bond, not a down payment. The CFTC’s glossary puts it plainly: “The margin is not partial payment on a purchase.”
• In retail forex: US rules set the minimum deposit for each trade, called a security deposit, at 2% of the trade’s notional value for major currency pairs and 5% for all other pairs.

Each is a different arrangement with its own rules. What they share is a small deposit standing behind a much larger exposure.

The SEC’s own example shows the arithmetic. An investor buys a stock at $50, paying $25 in cash and borrowing $25 from the broker.

If the price rises to $75, the $25 gain is 100 percent of the investor’s own money, against 50 percent for a buyer who paid in full.

If the price falls to $15, the buyer who paid in full has lost 70 percent. The investor on margin has lost the whole $25, still owes the broker $10, and owes interest on the loan on top.

The same stock, the same price, and two very different outcomes. Leverage does not change what the market does. It changes how much of the account each move takes with it.

For futures, the CFTC’s required risk disclosure says the same in one line: the high degree of leverage “can work against you as well as for you.”

In a US stock account the rules come in layers. Under the Federal Reserve Board’s Regulation T, an investor may borrow up to 50 percent of the purchase price of margin securities. After the purchase, FINRA rules require equity of at least 25 percent of the securities’ market value, and many firms set their own requirement higher, typically between 30 and 40 percent.

• The price falls: the securities lose value, and the equity in the account, their value less the loan, falls with them.
• The requirement is missed: in the SEC’s example, $16,000 of securities bought with an $8,000 loan fall to $12,000, leaving $4,000 of equity. That meets a 25 percent requirement of $3,000, but not a firm’s 40 percent requirement of $4,800.
• The call: the firm generally asks for more cash or securities, and until the call is met the account generally cannot buy more securities.
• The sale: if the call is not met, the firm sells securities to bring the equity back up to its requirement.

The sequence is less fixed than it looks. The SEC warns that a broker may not be required to make a margin call at all, and that under most margin agreements it can sell without waiting for the investor to meet one.

The SEC lists what an investor should understand before opening a margin account. Among the points:

• The investor can lose more money than was invested.
• The firm may sell some or all of the securities without consulting the investor, to pay off the margin loan.
• The investor is not entitled to choose which securities are sold.
• The firm can raise its margin requirements at any time, without advance notice.
• There is no right to an extension of time on a margin call.

Some investors, the SEC notes, “have been shocked to find out that the brokerage firm has the right to sell their securities that were bought on margin – without any notification and potentially at a substantial loss to the investor.”

Futures accounts settle gains and losses every day. The CFTC describes marking to market as the daily system that calculates each position’s gain or loss at the end of each trading session and adds it to, or subtracts it from, the account balance.

If the equity falls to or below the maintenance level, the broker must issue a margin call to restore it to the initial level. The CFTC’s risk disclosure warns that the call can be for a substantial amount, on short notice, and that a position not funded in time may be liquidated at a loss, with the customer liable for any resulting deficit.

In US retail forex, the dealer must collect more deposit or liquidate the customer’s positions when the deposits held fall short. The CFTC gives the scale: at a 2 percent requirement, a $2,000 deposit can open a $100,000 position, and the customer may be liable for losses beyond the initial deposit.

Elsewhere the limits differ. When ESMA restricted contracts for difference (CFDs) for retail clients in the EU in 2018, it capped leverage at 30:1 for major currency pairs down to 2:1 for cryptocurrencies, required providers to close out positions when an account’s margin fell to 50% of the minimum required, and ensured that retail clients cannot lose more money than they put in.

Before using margin, the SEC’s guidance points to questions an investor should be able to answer:

• Can I afford to lose more than the money I put in?
• Have I read the margin agreement, including what notice, if any, the firm must give before it sells?
• How much does the loan’s interest add to what the position must earn just to break even?
• Has the broker explained whether trading on margin suits my financial resources, objectives and tolerance for risk?

Leverage is a tool with a cost that is easy to miss: it shortens the distance between an ordinary price move and a forced sale.

Knowing the requirement, the size of the loan and the point at which a call would come belongs to the decision about size, made before a position is opened.

A written plan sets those limits as rules before the trade, not during it.

Your results will depend on your own decisions, your capital and market conditions, and you can lose money.