The interest on the borrowed funds—margin interest—is slightly higher than the prime rate that banks charge to their best customers. To use margin, the customer must open a margin account with a broker, and the money is borrowed from the broker. The interest rate charged by the broker will depend on how much the broker pays its bank for the money—called the brokers rate—plus whatever amount the broker decides to add. Typically, brokers have a sliding scale of margin interest that depends on the size of the individual trading account, with larger accounts paying a lower interest rate than smaller accounts.
Margin can also refer to the minimum amount of equity required to insure the performance of an obligation. A common example is the margin needed to short stocks. To sell a stock short, you borrow the shares from a broker, then sell them in the market, with the hope of being able to buy the shares back at a lower price. The proceeds of the stock sale are placed in your brokerage account. Although you are not buying the stocks initially, you will still be required to have a minimum amount of equity in your account before you can short the stock to guarantee that you will be able to buy them back later, even if the price of the stock is higher than the shorted price. You do not have to pay interest nor do you earn any interest on the sale proceeds, because the money is not yours, but is held as security to buy the stock back later.
Similar to the margin requirement to short stocks, the term margin is also used in futures and forex accounts that specify the amount of cash or cash equivalents, such as U.S. Treasuries, that are required to guarantee the performance of the futures or currency contract. In futures, the margin requirement is frequently referred to as a performance bond, because it is not borrowed money, but is a deposit that guarantees the performance of the contract at the time of settlement. A trader pays no interest on the margin in a futures or forex account—in fact, traders can earn interest by depositing U.S. Treasuries in a futures account to cover the margin requirement.
In futures and forex, the margin requirement is often expressed as a leverage ratio, which is inversely related to the margin percentage:
| Margin Percentage = | 100 ─────────── Leverage Ratio |
Example — Calculating the Margin Percentage from the Leverage Ratio
A 100:1 leverage ratio yields a margin percentage of 100/100 = 1%. A 200:1 ratio yields 100/200 = 0.5%. You'll often see these leverage ratios advertised by forex brokers. A 100:1 ratio allows you to buy $100,000 worth of currency while posting only a mere $1,000! Forex brokers can offer these low margin requirements because currency doesn't move with the same magnitude as stocks, especially in a short time, but the large leverage ratio does make currency trading very risky if all of the margin is used.
Leverage Ratio = 1/Margin Percentage = 100/Margin Percentage
Example — Calculating the Leverage Ratio from the Margin Percentage
Most stock brokers require at least a 50% initial margin, therefore:Leverage Ratio = 1 / 0.5 = 2
In other words, you can buy twice as many stocks using maximum margin than you can without using margin. Your investment is leveraged for greater profits or greater losses.
Margin ratios are usually much smaller in futures than for stocks, where leverage ratios are typically 10:1, which is equal to a 10% initial margin requirement, but this varies depending on the underlying asset, and whether the trader is a hedger or a speculator—speculators have a slightly higher margin requirement. Forex accounts have an even lower margin requirement, which may vary, depending on the broker. Regular forex accounts typically allow 100:1 ratios, which corresponds to a 1% margin requirement, and the typical ratio for a forex mini-account is 200:1.
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