Active stock traders use a brokerage margin account to trade stocks and use the broker's money to fund a portion of the trading activity. Trading on margin involves abiding by a set of rules concerning how much money the trader has in the account compared to how much is borrowed from the broker. A trader who runs afoul of the rules receives the dreaded "margin call" from the broker to send in more money.
Standard Margin Account
The regular margin account allows an investor to borrow up to half the cost of stocks in the form of a margin loan. If an investor buys the maximum amount of securities supported by the initial cash in the account, the account value will be 50 percent investor equity and 50 percent margin loan. If the value of the securities goes down, the percentage of investor equity also goes down. The maintenance margin limit is 25 percent investor equity. If the equity falls below that level, the investor must deposit more cash or sell some securities to pay down the margin loan and increase the equity percentage.
Day Trading and Consequences
Day trading is the buying and selling of securities -- usually stocks or exchange-traded funds -- during a single market day. The trader may buy a stock in the morning and sell in the afternoon, resulting in a day trade. If four day trades are executed through a margin account in any five-day period, the account will be designated as a pattern day-trading account. The day-trading designation puts the account under a different set of margin rules. The standard margin rules apply to securities and margin loans left in the account when the market closes and the day-trading rules apply during the day as a trader buys and sells securities.
Day-Trading Margin Limits
The day-trading margin limit is referred to as four times buying power. This means the day trader may open trades worth up to four times the account equity at the start of the trading day. The four-times buying power is double the two-times standard margin limit. Open day trades must be closed by the end of the market day to ensure the account is back within the standard margin rules when the stock market closes. The day trader must also maintain a higher level of absolute equity. A standard margin account must have at least $2,000 of investor equity. Once an account is designated as a day-trading account, the trader must maintain at least $25,000 of equity in the account.
Maintenance Margin and Day-Trading Margin
The limit of four times buying power for a day trader is based on the amount of equity above the maintenance margin limit. For example, the value of the securities in a trader's account is $200,000 and the outstanding margin loan is $130,000. The trader has equity of $70,000: $200,000 minus $130,000. The maintenance margin is 25 percent of $200,000, which equals $50,000. This trader has $20,000 of equity above the maintenance margin requirement. While day trading, the trader may open trades worth $20,000 times four -- $80,000.
Breaking Margin Limits
On a regular account, if equity falls below the maintenance margin, the broker will issue a margin call for more money to be deposited. If the investor fails to meet the margin call, the broker will sell securities out of the account to pay down the margin loan. If a day trader exceeds the buying power limit for day trading, a margin call will be issued and trading will be limited to two times buying power. If the margin call is not met within five days, the account will be restricted from day trading.
Tim Plaehn has been writing financial, investment and trading articles and blogs since 2007. His work has appeared online at Seeking Alpha, Marketwatch.com and various other websites. Plaehn has a bachelor's degree in mathematics from the U.S. Air Force Academy.