Introduction to margin accounts

Margin

The simplest understanding of margin, is that it allows investors to borrow money, to leverage their money. This process can be used in long positions, when the client wants to borrow money in order to buy more securities then the money in their accounts would allow. It is also the only place where investors are able to short securities. In order to borrow securities, and then sell them short, that must be done in a margin account.

Margin account documentation

There are basically 4 named parts of the margin account documentation you need to understand, and not get confused.

Credit agreement

With margin accounts, the investor is borrowing money. With all extensions of credit when it comes to loaning/borrowing money, there is a credit agreement. This is a **required **document in the margin packet, and would explain the interest rates, and parts of the process like that.

Hypothecation agreement

Pronunciation is not tested on this exam, so don’t worry about that. Hypothecation is the investor pledging their securities to the broker dealer as collateral for the loan in the margin. If the investor doesn’t meet the required margin or maintenance calls, this is what allows the broker dealer to sell the securities to make the required calls. This is a **required **document in the margin packet.

Loan consent agreement

Margin accounts are the only way you can short stock; that is selling stock now when hopefully it is higher and then buying it in the future, when if you are correct, it will be lower. That can only be done in margin accounts. To do that you have to borrow the securities you plan on selling. You are borrowing someone else’s securities. This document is asking if you want to lend other people your securities. You do not have to, this is an optional part of the margin packet, but you’d get some of the interest. If you have no plans on selling the securities for awhile, you would generate some extra income by lending to others, but, it is your choice, unlike the other parts, you do not have to sign this. Again, loan consent is optional.

Margin disclosure document

There are additional disclosures required in margin accounts, that must be made when the account is opened and annually thereafter. Included in the disclosures would be’

• The investor can lose more money than they initially invested.
• The firm has the right to force sale of securities in the account, against requests of the client.
• The firm is allowed to sell securities without consulting the investor.
• The firm may change its house margin requirements, at any time, with no advanced notice/warning.
• Investors, as stated earlier, as not entitled to an additional extension of credit.

Margin account agreement

Basically the combination of all documents opening the margin account.

Regulation T

Reg-T is controlled by the Federal Reserve Board, and was given to them with the Securities Exchange Act of 1934. It functions in 2 primary areas when it comes to borrowing money with securities.

• It sets the date payment, when payment is due for the purchase of securities. Investors have 2 days after the settlement date in order to pay.
• It sets the amount and method credit can be given for use in margin accounts.

The 2-day extension to pay, is pretty easy to understand. It can be thought of as either 2 days after settlement, RegT=S+2, or 3 days after the trade date, RegT=T+3, as settlement is 1 day after the trade date, S=T+1.

If the debt is not paid within those 3 days, there can be a request for an extension to FINRA, but do not expect it. In the modern world, there aren’t any likely reasons someone would be delayed. Most things, in the real world, basically settle immediately, with electronic networks and similar, the reasons for an extension now, are far rarer than 50 years ago, and the mailed money order, might be delayed. If that extension is not granted, the account will be frozen for 90 days. An account that has been frozen, means all payments must be made in full, before any transactions can be made. Once unfrozen, the 3 day normal payment window will be allowed again.

The credit dealing with margin accounts, gets a bit more complicated. For cash accounts, that number is 0%, 100% of a cash account must be deposited in cash, no borrowing allowed. In margin accounts, 50% is the current Reg=T amount that can be extended on credit for margin. 50% is the current Reg=T margin requirement, and initial deposit, for both long and short margin accounts.

Margin calls and maintenance calls

There is an expanded risk in margin trading. If you borrowed $50, and combined it with your $50, and went and bought something for $100, if that starts to fall in value, their would come a point where you might just want to walk away. If the value of the item falls to $50, then the bank would effectively own all $50 of it. That is why, before the market gets to $50, you would need to add more in for collateral.

The initial deposit that is required is called the margin call. Margin call, as set by Reg-T, controlled by the Federal Reserve Board, is currently 50%, meaning if you wanted to go long or short, you would need at least 50% down payment.

The additional collateral calls, which might be required if the equity in the account falls too low, is called the maintenance call. Maintenance call, also set by Reg-T, is 25% for long margin accounts and 30% for short margin accounts. If the equity falls below that level, additional collateral is required, and that will be done by the firm sending out a maintenance call. Failing to meet that maintenance call, would then have the firm liquidate the position. If liquidation is required, the account holder doesn’t have any say, it is the company’s choice on what gets liquidated to meet the maintenance call.

Each firm can set its own house margin requirements. Those can be any number, provided they are higher. They cannot be lower than the Federal Reserve Board’s Reg-T requirement. Firms can change their house margin requirements, at anytime, with no advanced notice needed.

In the section on the mathematics, we will go through more examples in detail, but basically to find the percentage equity, and check if it’s at 25% or 30%, simply take the equity and divide it by the respective market value, either LMV, for long account, or SMV for short margin accounts.

Marginable securities

Marginable securities are those securities that can be traded on margin. There are securities that are marginable and can be bought and sold on margin, and there are non-marginable securities, which can be bought and sold in a margin account but cannot be bought and sold on margin. Non-marginable securities must be 100% purchased in cash.

Marginable securities would include listed stocks, listed bonds, ETFs, and similar types of investments. There is a full list, which is very long, but basically, most things are marginable.

Non-marginable securities would include options, penny stocks, OTC stocks, and recent IPOs. You must hold the IPO shares at least 30 days before they would be considered marginable, and they would, of course, have to follow the other rules. If the IPO was for penny stocks or OTC stocks, they would not be marginable.

Mutual funds cannot be purchased on margin, but can be deposited in the account, if fully held for 30 days, to meet maintenance and margin calls.