While researching how margin accounts work, I noticed that only very few websites are fully clear in their explanations and difficult to understand because they lack practical numerical trading examples. With this page about cash and margin accounts I want to explain the principles and mechanisms that are applied when trading stock and options and illustrate them with easy to understand numerical trading examples.

Let’s kick off with explaining the difference between both types of accounts.

Cash accounts

Although one needs to check the broker’s requirements to see what is exactly allowed, usually for cash accounts, traders are obliged to have a sufficient amount of money upfront in their cash account to cover the entire risk when entering a trade.

The broker wants to make sure that the risk of each trade is fully covered by the trader at all time. In other words, the buying power requirement for any trade in a cash account is equal to its maximum risk, this means that in a cash account the trader must be able to cover the full purchase price with the money already in your account.

When you submit a trade on the trading platform, before accepting and executing the trade, the broker will analyse the maximum risk for each trade and determine the amount of cash you will need in case the maximum risk occurs. For example, in case you need to buy back the shares after shorting them, or for example the sum of cash you need to fulfil the obligation of buying shares after option assignment. The broker will put all risk with the owner of the account and obliges that all requirements are met at all time. For some types of trade the maximium risk is unlimited and the broker will not allow them at all.

In general, with a cash account, you can only buy securities with the cash that you have deposited in your account. The broker just won’t allow you to buy more than the amount of cash available (the broker won’t provide a loan). If you want to buy more than there is cash available, you’ll have to fund extra cash to your account or sell some of your investments in your account first.

I have trading accounts on Interactive Brokers and on Tastytrade, so let’s figure out what their requirements are for cash accounts for trading stocks in general and for trading options in particular.

Trading stocks in a cash account

In regard to stock transactions, Interactive Brokers states on their website for stock transactions: “… that a cash account must have enough cash to cover the cost of stock plus commissions…” and that “shorting is not allowed“. Tastytrade applies the same rules for stock transactions in cash accounts: buying stock is allowed, all costs covered, and short selling stock is not allowed.

That is very clear to me. Now how does this work?

Example: Imagine I have opened a cash account and I’ve made a deposit of $25.000. I want to buy 300 NIO shares via a limit order at $55.00 a share. The purchase cost for the trade will be 300 x $55.00 = $16,500. I need to consider the broker’s fee and commissions and the taxes for this trade. Let’s consider fees and commission to be $3 and the tax $55, which brings the total purchase cost for this trade at $16,500 + $3 + $55 = $16558. In order the broker to execute the transaction, I will need to have a minimum of $16558 in cash available in my cash account. I have $25.000 so my order will be accepted.

Trading options in a cash account

For Interactive Brokers, I can find on their website that: “Full payment must be made for all call and put purchases. Covered call writing is allowed, but the underlying stock must be available and is then restricted. Naked put writing is also allowed, but the funds must be available and then are restricted.“

For Tastytrade, we read on their website that in a cash account it is possible to buy options, write covered calls and write cash-secured puts. Writing covered calls requires you own the shares you are selling a call option against. Writing cash-secured puts means that selling a put option requires a sufficient amount of cash in your account to cover the possibility that the option is exercised and you will have to buy the shares at strike price (aka cash covered put). The required amount of cash available in your account, for selling a cash-secured put, equals ((number of contracts x 100 x (strike price – minus the received premium).

Example: Imagine I have $25.000 in my cash account. I want to sell one put option contract for AAPL (trading at $130) at strike price $100 with a 45 days till expiration. The price for this option on the option market is $2.50 per share. I will receive a premium of $250 to sell one contract. In order for the broker to allow me to execute the trade, the maximum risk of selling one put option must be cash-secured (the maximum risk for me is getting assigned to buy the shares).

The total cash-secured amount required is ((number of contracts x 100 x (strike price – minus the received premium) = (1 contract x 100 x ($100 – $2.50)) = $9,750. And because I have $25.000 in my account, the order will be accepted. Keep in mind that I will have to keep this cash reserved to cover this particular trade until the position is closed.

So basically both brokers allow 3 types of option trades for their cash accounts:

• Buying options: meaning you pay with the cash available in your account; the maximum risk is that the option becomes worthless but because it is payed for when opening the trade, the risk is covered.
• Selling covered calls: this trade is only allowed if the underlying stock is held in the account; the maximum risk here is that you are assigned to sell the stock and since you already own and paid for them, this risk is covered.
• Selling puts: this trade is only allowed if the assignment of the puts is covered (or secured) by sufficient cash in your account to also cover this risk.

Notice that selling naked calls or puts is not approved with a cash account. Brokers are “middlemen” in transactions and they want insurance that traders can meet their obligations at all time, otherwise the broker risks to loose money. When a trader sells a naked call, there is basically an unlimited risk because the stock can go up infinitely, giving unlimited risk. Selling a naked put gives also high maximal risk because the stock gan drop to zero, giving a complete loss in value of the shares the trader is obligated to buy. These are in theory the riskiest option trades one can do and that is why brokers won’t allow these trades in a cash account.

Therefor, we can conclude that a cash account isn’t fit for option traders whom primary strategy is selling options. You can’t sell naked calls or puts, or any kind of combination of these two (strangle, iron condor, credit spread,…).

In regard to the analysis of ROI calculations of trades, it is clear that the investment of the trade is equal to the cash requirement for that trade, because this capital is “required reserved capital”, “cash-secured” or “blocked” (or restricted as Interactive Brokers calls it) by that trade.

Margin accounts

Now let’s take a look how a margin account works.

I realise that it is a lot of information at first and can feel overwhelming, but bear with me, it is paramount to understand precisely how things in a margin account work because trading on margin creates opportunities but involves additional risk. So be sure you understand the requirements and industry regulations that govern margin borrowing, before placing any trades.

Let’s define “margin”: we consider the “margin” of a trade to be the portion of the total transaction (purchase price) that is contributed by the trader.

When a trader applies for a margin account and gets approved by the broker, the trader gets easy access to a source of debt through borrowing money from the broker, also known as “trading or buying on margin.” The broker is prepared to borrow money to the trader whenever the trader wants to buy more securities than there is cash available in the margin account.

Brokers are willing to take the risk of borrowing the money to traders. Firstly because the broker gets to charge interest on the borrowed amount, for the period of time that the loan is outstanding. Secondly, because the broker can limit his risk by using the cash and the securities in the margin account as a collateral to secure the loan. There are however specific legal and brokerage rules and requirements that must be respected by the broker and the owner of a margin account at all times, to limit the financial risk for both parties. The legal requirements requirements are different depending on the kind of transaction (and thus also the risk). In addition to the minimum legal requirements, most brokers will set even stricter requirements for margin accounts, often based on the trader’s profile, the broker’s policy, market situation and the account situation.

The overall margin requirement for a portfolio takes into account the different margin requirements for all held positions separately, which can make the actual required margin at account level sometimes look hard to grasp at first. To fully understand the numbers, you need to look at the different calculations for requirements for each positions separately. Luckily the trading platforms will make the calculations for us and give the projections before a trade is submitted and executed. But because I want to fully understand how this works, I will focus in this article mainly on clarifying the mechanics and requirements for trading stock and options in a margin account.

Now, another important element to understand about trading on margin, is that when the price of the securities (stocks) goes up or down, the amount the trader owes to the broker (the loan) and that must be repaid some day, remains unchanged only varying maybe a little bit with the charged interest.

It is clear that a margin account gives more flexibility and possibilities to the trader because it allows the trader to make bigger investments with less own money. This principle is also known as creating leverage. But with leverage comes more risk, because buying securities on margin means using leverage also means that in case of lowering share prices the losses for the trader can expand quickly and the borrowed money always needs to be repaid as well.

Let me show you with an example how leverage works.

Example: Imagine I have a margin account and have deposited $10,000 in cash in the account. And let’s say the broker is prepared to borrow me as much as the same amount as my own contribution to a new purchase, being also $10,000. With this $20,000 of available cash, I buy 100 shares of stock at $200 a share (I don’t consider the fees, taxes and commission here because the aim of the given examples is just to illustrate the margin mechanism).

If the stock rises to $250 and I decide to sell, I will collect $25,000. After repaying the open loan of $10.000 to the broker, I will still have $15,000 left which means I’ve made a net profit of $5,000 on my $10,000 investment or a ROI of 50%. If I had used only my own cash, I could buy only 50 shares at $200, and would have sold the 50 shares at $250 for a total of $12,500 meaning that I would have made a net profit of $2,500 on a $10,000 investment or a ROI of 25%.

If after my purchase the stock falls to $150 and I decide to sell to cut my losses, I will collect $15,000. After repaying the $10.000 to the broker, I will have $5,000 left which means I’ve made a net loss of $5,000 on my initial investment or a ROI of -50%. If I had just used only my own cash, I would have bought only 50 shares at $200, and would have sold the shares for $7,500 meaning that I would make a net loss of $2,500 on a $10,000 investment or a ROI of -25%. As you can see from this example, being on margin creates leverage and can potentially double your profit or your losses, depending on the direction of the stock price. This is what leverage does.

As said before, brokers have to limit (by law) their own risk at all time by keeping the securities and/or cash held in the margin account as a collateral for the loan. Brokers want to make sure that the margin account has enough equity or value to pay back the loan, at any given time. Brokers do this by requiring the trader to keep the equity of the account above a minimum level so that the loan can be repaid (taken or claimed is a better word) at all time.

What is equity? The equity in an account is real value owned by the trader = the total value of cash in the account + the vaIue of the securities in the account – the liabilities (loans or debts) of the account.

Imagine that in the same example, where I have bought 100 share at $200 a share with a 50% margin (meaning my contribution was 50%). The equity of my account, after the trade, equals ($0 cash + $20,000 stock value – $10,000 margin loan)= $10,000.

Great! Now that we know the general leveraging mechanism of a margin account, let’s take a look at the most important requirements that need to be respected.

Margin Requirements

Because I am trading mainly on the US stock and option markets, I will focus on the rules for the US markets. Be aware that the mechanisms, the principles and the regulations for margin accounts are similar for other countries too. I will look into the rules-based model also known as Reg T accounts, which is the type of margin accounts most trader have or start with.

In the US, the terms on which firms (brokers) can extend credit for securities transactions are governed by federal regulations and by the rules of FINRA and the securities exchanges. It is important to realise that the rules and the margin requirements for a transaction are defined for the every different type of transaction.

I am mainly interested in selling options, but in order to illustrate the mechanism for margin accounts, let’s consider the most important margin requirements for buying stocks on margin first. Understanding the mechanism for buying stocks, will help us understand the mechanism for the other types of trades.

Buying stocks on margin

As mentioned, the margin requirements are formulaic and depend on the type of trade. Here are the three main requirements:

• Minimum margin requirement (before you can trade): Legal regulations determine the bare minimum amount of cash that traders need to deposit in a margin account before trading on margin or before selling short becomes possible. For US brokers this amount is minimum $2,000. Brokers can set their own more strict minimum funding requirements for a margin account if they want.

• Initial margin requirement (amount you can borrow): this is the portion of the total purchase price (expressed in currency or as a percentage), that the trader must pay with his own cash (or cover with margin-eligible or marginable securities – we explain this possibility later) to open the position. So basically, the initial margin requirement determines how much a trader can borrow to make a new trade. In the USA, according to SEC regulations, the broker is not allowed to borrow more than 50% of an investment’s value. Very often brokerages will define their own, more strict, limitations (often based on the risk) on how much can be borrowed to buy on margin.

Example: The initial margin requirement for a $20,000 stock purchase is a contribution of $10,000 from the trader’s account (picture 1).

• Maintenance margin requirement (amount you need after the trade):
  • this is the minimum equity (value of cash plus market value of securities minus liabilities) that a trader must maintain in the margin account as collateral for the loan, after the positions have been established (stocks are purchased), until the position is closed.
  • It is paramount to understand that the maintenance margin goes into effect after the purchase (where the initial margin requirement was applied) once the position has been established.
  • The maintenance margin requirement (MMR) can be calculated for one single position or calculated at account level for the different positions together. The MMR for a long stock position (long aka purchased stock) expressed in currency ($ in our case) is equal to the total actual value of the securities multiplied by the margin requirement (%).
  • To calculate what level of margin the margin account has at any given moment, you can divide the equity of the account by the market value of the securities held in the account.
  • For brokers under US regulations, the trader’s minimum equity in the account must not fall below 25% of the current market value of the securities in the account (in other words after the initial margin of 50% for opening a position, the margin percentage can drop but has to remain above the minimum 25% level).
  • This minimum requirement (of available means to be held in the account) protects the broker from the risk, when things go bad, that the means in the account won’t be a sufficient collateral to cover the loan that was provided. If at any given time an account’s margin falls under the set maintenance margin requirement, the broker will give the trader a margin call, to indicate that an additional deposit of more money or securities in the account is required or that investments held in the account needs to be sold to maintain the minimum account value that acts as collateral for the received loans. In some cases, if the trader doesn’t respond to this request, the broker may sell investments without notifying the trader to pay down the loan. Some brokers will even proceed immediately to the liquidation of the stock when the minimum requirement level is reached.
  • Keep in mind that initial margin requirement is different from maintenance margin requirement.

Example: A 30% maintenance margin for a stock with a value of $40,000 means a minimum equity to keep of $40,000 x 0,30 = $12,000.

In the example with the ABC shares below: after the purchase and with the same initial share price, the maintenance margin requirement is $20,000 x 0,25 = $5,000 (meaning I need to have more than $5,000 equity to meet this requirement).

So basically, remember that the initial margin requirement determines how much you can borrow to open the position and the maintenance margin requirement determines how much value you need to keep in your account as collateral after the position has been established. The maintenance margin requirement is an ongoing requirement that fluctuates with its determining parameters.

It is important to realise that brokers can restrict the requirements even further based on own policies and individualised risk analysis. So always check the terms of a margin account of your broker.

The possibility of borrowing money from the broker increases the total amount of money a trader can spend to make transactions: it increases the trader’s buying power. The buying power value of a margin account serves as a measurement for the trader, indicating how much money a trader still has available to buy securities without depositing additional funds or securities.

It is paramount to understand that the equity of a margin account changes constantly, together with the value of the securities in the account.

With the equity of an account = the total value of cash in the account + the vaIue of the securities in the account – the liabilities (loans or debts) of the account, you can easily understand that if the securities in the account decline in value, the value of the collateral supporting the loan also declines. Imagine a serious drop in value of the securities in the account, so low that the total equity of the account is below the amount of the broker’s loan, then the broker is no longer sure that the provided loan can be repaid. In order to avoid such a risky, money loosing situation, the broker will require the trader to keep a minimum level of equity in his account, called (as you know by now) the maintenance margin requirement.

Let’s illustrate these margin requirements with an example and some numbers.

Example: Let’s consider a trader with a margin account with $15,000 in cash deposited. The broker’s terms for trading stocks in a margin account allows the trader to open new positions at a 50% margin (in other words, the portion of the trader for every new trade has to be minimum 50%, equal to the minimum initial requirement set by legal regulations). This means that the trader has a buying power with the $15,000 deposit and the loan possibility of another $15,000 of $30,000 in total. The account’s starting numbers are:

• Cash: $15,000
• Cash Balance: Cash – outstanding loans = $15,000.00 – $0.00 = $15,000.00
• Buying Power: $30,000.00
• Stock value: $0
• Equity of the account: ($15,000 cash + $0 stock value – $0 margin loan)= $15,000.00

The trader wants to buy 100 XYZ shares at the price of $200.00 for a total purchase price is $20.000. When the trader submits his order to buy the XYZ shares via his margin account, the broker will use the available $15,000 in cash in the margin account and will borrow $5,000 to the trader to have sufficient cash to pay for the stocks. The broker will only loan the money if the 50% initial margin requirement for this new trade is met : with a margin =(portion/total purchase cost) = ($15,000/$20,000) = 75%, the trader fulfils that requirement and the broker will allow the execution of the trade.

After the trade, the maintenance margin requirement kicks in and is set by the broker at 25%. This means that the margin at account level = (the account equity / value of the securities) needs to be maintained above the 25% level. So, after buying the XYZ stocks and the position is established (picture 2), the numbers of the margin account are:

• Cash: $0 (all cash is used for buying the stock)
• Liabilities: $5,000 margin loan (on which interest needs to be paid)
• Cash Balance: – $5,000 (cash – cash liabilities)
• Shares purchased: 100 XYZ shares at $200.00 per share -> total: $20,000
• Equity of the account :($0 cash + $20,000 stock value – $5,000 margin loan)= $15,000
• Maintenance margin requirement (account equity/ value securities) is set at 25%. With the account equity at $15,000 and the value of the held securities at $20,000, the margin of the account is still at 75%, well above the minimum level of 25% (meaning that the broker will continue providing the loan)
• With $0 in cash and no other securities in the account, the bought XYZ stock are to be kept in the margin account (no transfer to another account is allowed), as collateral for the loan. This will be required until the loan of $5,000 has been repaid or until extra cash or securities are deposited to guarantee the minimum margin requirement.

You will understand by now that maintenance margin requirement is based on the current market value of the securities (stocks), and not on the purchase price. Now, let’s consider what happens to the margin requirement and the account numbers after opening the position and let’s look more in particular what the impact is of a fluctuating share price of the bought stock (the price of the bought shares start going up and down) :

• with XYZ stock at same price (picture 3)
  • margin remains at 75% -> ok
• if the stock raises to $250.00 (picture 4)
  • Stock position value = 100 x $250.00 = $25,000
  • equity of the account = ($0 cash + $25,000 stock value – $5,000 margin loan)= $20,000
  • MMR = $25,000 X 0,25 = $6,250
  • margin = ($20,000/$25,000) = 80% -> ok because is above 25%
• if XYZ stock drops to $150.00 (picture 5)
  • Stock position value = 100 x $150.00 = $15,000
  • equity of the account = ($0 cash + $15,000 stock value – $5,000 margin loan)= $10,000
  • MMR = $15,000 X 0,25 = $3,750
  • margin = ($10,000/$15,000) = 66,66% -> ok because is above 25%
• if XYZ stock drops to $60.00 (picture 6)
  • Stock position value = 100 x $60.00 = $6,000
  • equity of the account = ($0 cash + $6,000 stock value – $5,000 margin loan)= $1,000
  • MMR = $6,000 X 0,25 = $1,250
  • margin = ($1,000/$6,000) = 16,66% -> is not ok because is below 25%

• How low can share price drop to respect the minimum 25% margin?
  • The formula to determine the minimum value is, with Margin Requirement (M), Cash value (C) and the Loan value (L)
  • -> M = 0,25 = (C+V-L)/V
  • -> V=(L-C)/(1-M)
  • -> with M set by the broker at 0,25 and no cash held as collateral for the position, the minimum value of the securities to respect the minimum margin requirement -> V=($5,000-$0)/(1-0,25) = $6,666.
  • Minimum share price = (V / Qty of shares). This means for a position of 100 shares, a minimum share price of $66.66 gives an equity of the account = ($0 cash + $6,666 stock value – $5,000 margin loan)= $1,666 and consequently a margin = ($1,666/$6,666) = 25% -> ok is at minimum level.
  • If the trader can sell the stock for $50.00 or more, and with no cash in the account, the trader can still repay the $5,000 loan, but the broker doesn’t allow the trader to take that much risk. If the share price drops lower than $66,66 (below the 25% margin level) the broker will send a margin call to the trader because the minimum margin requirement is no longer maintained.
  • The trader must respond to the margin call by depositing more cash or securities as collateral in the margin account, otherwise the broker will sell the shares at market price and close the position to have the loan repaid.
  • Obviously the trader would take a big loss if this happens. The net loss, if the stock was sold at $66,65 would equal $13,335 = ($15,000 – (($6,665 – $5,000).

The examples for buying stocks on margin gives us good insight how this actually works. Now let’s look how this works for selling stocks.

Selling stock in a margin account

Legal regulations about margin accounts regulate the way brokers are allowed to lend to investors. Traders need to have a margin account to short sell stocks, because shorting is basically selling stocks you do not own. The broker will borrow you the shares, for you to sell, but wants to have them returned later in time. For this type of trade, also strict margin requirements are defined, acting as collateral, to ensure that the shares (or the cash value of them) will or can be returned in the future.

It is clear that traders do this type of transactions when they expect the value of the shares to drop. If the price drops, after the trader has sold the shares, and the trader buys them back cheaper, in order to return the stock to the broker, the trader obviously makes a profit. If the price increases, and the trader needs to buy them back at a higher price, he takes a loss.

In order to limit risks, legal regulations are put in place to regulate these kind of transactions. The basic principles if initial and maintenance margin apply here also. The US regulations (and other countries have similar regulations) require, for shorting stock transactions, the margin accounts to have an initial margin requirement of 50% on top of the 100% value of the short sale at the time the sale is initiated. Furthermore is a minimum maintenance requirement set of 130% of the actual value of the stock, being the amount to hold in the account after the trade. This requires short traders to have, in the margin account, 50% of the value of the position at the time the short is initiated and 130% to be held after the trade. Brokers can set a higher maintenance requirement if they want to.

Because the trader (selling short) has the obligation to buy back the shares in the market at some point, to return them to the broker, the broker will deposit the proceeds of the short sale in the account of the trader. And he requires the trader to keep sufficient cash (the maintenance margin requirement) available the account in case the stock price rises, and the trader would need to pay more than he received to buy back the stock.

Example: If I want to short sell 100 shares of ABC at $50.00 per share. I need to have ($50 x 100 x 0,5) = $2,500 in my account in order to have the transaction executed. The amount of the sale $5,000 is deposited in my account. After the trade, I will have $7,500 in my account. And I have to keep a minimum of 130% of the stock value available in my account, as a collateral to the loan of the stocks, until the position is closed. At the purchase price of $50.00, my MMR after the trade is $6,500. So with the $7,500 in my account I meet the requirement.

When the stock price rises to $55.00, the MMR increases to $55 x 1,30 = $7,150 (and I am still ok). But when the stock rises to $60.00, the MMR will increase further to $60 x 1,30 = $7,800 and I no longer meet the minimum requirement. I will get a margin call to deposit more cash or to close the position and return the shares.

Trading Options in a margin account

It is important to realise that the calculations for trading options on margin is much more complicated than with stocks and that each broker can have different margin requirements depending on what option strategy is used. You will see that every strategy will have its own specific way of calculating the required margin requirement. So I strongly suggest to take a look at these requirements on the broker’s website and to see how the different margin requirements are calculated.

The maintenance margin requirements for options are often the same as the initial margin requirements.

I have also noticed during my research that the indicated margin requirements didn’t always matched my own calculations for some unknown reason. I’ve contacted my brokers to get extra information about this and I will updated this page when required.

Now whenever I want to make open a new position, the broker will check if the account for that specific trade meets the margin requirements. If not the trade will not be allowed and not executed.

Let’s take a look at some examples for naked puts.

Selling Naked Puts

Imagine I have been following stock AAPL for a while now and it is currently trading at $120. And I believe the stock will go back up, but in case it doesn’t rebound, I wouldn’t mind buying it, if it drops further to $90.00. My trade is selling a put option with strike price $90.00 with 45 days till expiration (DTE) and this option trades at $2.00 per share on the option market. This trade would allow me collect a total credit of $200.00

I have a margin account so the next question here is: what is the initial margin requirement the broker is asking to allow the trade? What formula to use to calculate the margin requirements for options?

As mentioned, brokers may use slightly different formulas to calculate the margin on options, for as long as they respect the minimum legal requirements. So check with your specific broker regarding your margin account obligations. The used formula will depend on the selected option type or selected strategy.  I have a margin account at International Brokers (IB) and one at Tastytrade (TT), so for this article, let’s examine their requirements.

At Interactive Brokers, the initial margin requirement for a naked put is defined as: Put Price + Maximum ((20% x Underlying price – Out of the Money Amount), (10% * Strike Price))

The put price is the total premium received. The result of the Maximum formula is the highest of the calculated values between brackets.

At Tastytrade, the buying power reduction refers to the amount of capital required to place trades and maintain them, which is in fact to be considered to be the margin requirement because it is the amount of capital that will be tied up trading stocks or trading options. The buying power reduction is based on the greatest of the following three formulas:

• 20% rule: 20% of the underlying, less the difference between the strike price and the stock price, plus the option value, multiplied by number of contracts
• 10% rule: 10% of the exercise value plus premium value
• $50 Plus Premium Value: $50 multiplied by number of contracts, plus premium value. 

Conclusion

The difference between a brokerage cash account and a margin account is a bit like the difference between a debit card and a credit card. Both cards let you buy the things you need and provide easy access to money, but purchases on a debit card are limited by the cash balance in your bank account, while a credit card extends you a line of credit, letting you buy more (potentially much more) than the cash you have on hand.

I hope this article helps your understanding of how margin accounts work. Feel free to comment or ask any question in the comments section below.

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