At brokerage firms, there are two main types of accounts: cash and margin accounts. Cash accounts require investors to pay 100% for each security transaction and prohibit strategies that involve unlimited loss potential like short selling securities. Margin accounts allow investors to borrow money for investment purposes and allow risky strategies. In fact, margin accounts are required for short sales and any other strategy involving unlimited risk (like short calls).
When an investor borrows money for investment purposes, they leverage themselves. Leverage involves amplified gains and losses. Investors utilizing margin accounts are able to make more money when they make the right investments, but also are subject to more losses when the market moves against them.
Imagine you have $5,000 of your own money and borrow another $5,000 from a friend. Then, you take all $10,000 to the casino and bet it all on one game. If you win, you double your money to $20,000, which would make you more money than if you only had your $5,000. If you lose, you not only lose your $5,000, but also your friend’s $5,000 that you owe back to them.
Borrowing money for gambling works the same way as investing. Investors make more money if they make the right investment, but could lose more if they’re wrong. There’s a fair amount of risk involved with margin accounts, which is why they’re only suitable for risk-tolerant investors that can withstand losing significant amounts of money.
In this chapter, we’ll discuss how margin accounts work, the regulations that govern them, and how investors utilize them.
Margin accounts require more than just a basic new account form. Customers opening margin accounts must fill out and sign the margin agreement, which contains three subsections: the hypothecation agreement, credit agreement, and loan consent form.
The hypothecation agreement is a bizarre-sounding form, but it involves the customer pledging their securities as collateral for their margin loans. Just like a home is collateral for a mortgage, securities held in a brokerage account serve as collateral for margin loans. If a customer borrows money from their broker-dealer and is unable to repay the loan, the broker-dealer can liquidate (sell) the securities in their account to pay off the loan.
Broker-dealers are not banks and do not have significant amounts of cash available to lend. Therefore, they rehypothecate (re-pledge) their customers’ securities to banks in return for a loan. The relationship between the bank and the broker-dealer is governed by Regulation U, which allows the broker-dealer to rehypothecate securities up to 140% of the amount of the customer’s loan to the bank. For example, if a customer borrows $10,000 through a margin loan, the broker-dealer may rehypothecate $14,000 of the customer’s securities to the bank as collateral for the loan.
Broker-dealers then take the borrowed money from the bank and re-loan it out to their customers with a slightly higher interest rate. The difference between the interest rate paid by the broker-dealer to the bank (known as the broker loan rate) and the interest rate charged to the broker-dealer’s customers is how broker-dealers make money off margin accounts.
The credit agreement is where the details of the margin loan exist. The way the broker-dealer calculates their margin interest, repayment schedule, and general terms of the loan are included in this part of the margin agreement.
The last part of the margin agreement is the loan consent form. If a customer signs this part of the margin agreement, they’re agreeing to allow the broker-dealer to lend out their securities to other customers for short sales. If you recall, short sales of securities involve borrowing securities from a broker-dealer, selling them, and hopefully buying the security back after the price drops. Borrowed securities come from other customers of the broker-dealer that own margin accounts. This occurs behind the scenes; margin customers won’t know when their securities are being borrowed.
When a customer has a loan consent form on file, their securities will be commingled with other customers’ securities. This means that their stocks, bonds, and other investments may be held in other customer accounts. This cannot be done with cash accounts, as fully paid-for securities held in cash accounts must be segregated and held in safekeeping for each investor.
The loan consent form is the only part of the margin agreement the customer is not required to sign. By law, the hypothecation agreement and credit agreement must be signed in order for a margin account to be opened.
Deposit requirements represent the amount of money required to execute an investment strategy in a margin account. Investors are subject to Regulation T or FINRA requirements when borrowing money from their broker-dealer.
Regulation T is a rule within the Securities Exchange Act of 1934 that requires investors to make a 50% deposit when borrowing money or securities for investment purposes. The Federal Reserve has control over this rule. Investors utilizing margin typically are required to deposit 50% of the overall transaction.
Sometimes investors must deposit more than 50% of their transaction. FINRA requires a margin equity (ownership) level of $2,000 in order to make use of margin loans. Applicable margin regulations require a deposit of the greater of their Regulation T and FINRA requirements.
Let’s go through an example to better understand this concept.
An investor opens a new margin account and subsequently executes a purchase of 100 shares of ABC stock at $30. What is their deposit requirement?
Can you figure it out?
Answer = $2,000
The investor is purchasing $3,000 of stock (100 shares x $30). They must deposit the greater of 50% or $2,000. A 50% deposit equals $1,500. Therefore, the investor must deposit $2,000 to execute this transaction.
What if an investor purchases less than $2,000? For example, an investor purchases $1,200 of a security. Would it make sense to require a deposit of $2,000 if their maximum loss was $1,200 (assuming the stock became worthless)? No - it wouldn’t. Therefore, investors only must deposit 100% of the transaction if purchasing less than $2,000. Essentially, their account is treated as a cash account.
Margin initial deposit rules for long accounts can be summed up this way:
| Purchase amount | Deposit amount |
|---|---|
| $2,000 or less | Entire amount |
| $2,000 - $4,000 | $2,000 |
| $4,000 or more | 50% (Regulation T) |
These rules are a bit different for short accounts. When an investor sells short stock, they can lose more than the initial value of the investment. For example, assume an investor goes short 100 shares at $15. Although the initial short position is only $1,500, the investor could lose an unlimited amount of money if the stock were to rise considerably. If the stock price went to $50, they would be obligated to spend $5,000 buying it back ($50 x 100 shares), resulting in a $3,500 loss ($1,500 short sale - $5,000 repurchase).
Due to the heightened risk of short positions, margin rules always require a minimum deposit equaling the greater of 50% or $2,000. Most importantly - even a small initial short position well below $2,000 will require at least a $2,000 deposit for example:
An investor opens a new margin account and subsequently executes a short sale of 10 shares of ABC stock at $40. What is their deposit requirement?
Even though the position is only worth $400 (10 shares x $40), the investor must deposit a total of $2,000. Unlike long positions, purchases below $2,000 still require a deposit of at least $2,000. If the same example above was switched to a long purchase of 10 shares at $40, the investor would only be required to deposit $400.
Regulation T also relates to settlement for both margin and cash accounts. Although different securities have their own settlement times, Regulation T settlement is always two business days after regular-way settlement. This is the last day the cash for a purchase or the securities for a sale can be delivered.
If an investor does not deposit the required cash or securities for a transaction by Regulation T settlement, the broker-dealer maintaining custody of their account must take action. They can reach out to the appropriate SRO (usually FINRA) and request an extension for the customer, or can close out the position for the client and freeze their account.
If the firm obtains an extension from an SRO, it gives the customer an extra few days to fulfill their obligation. For example, if a customer owes $10,000 for a recent security purchase, they’ll get a few extra days to make the $10,000 deposit. Extension requests occur infrequently and are sometimes denied.
The more common process is liquidating a customer’s account and freezing the account. Again, let’s assume a customer owes $10,000 on a recent security purchase. If the required deposit isn’t made by Regulation T settlement (two days after regular settlement), the firm has the right to liquidate $10,000 of securities in the customer’s account. They’ll keep the $10,000 to pay for the transaction, then freeze the customer’s account.
When a brokerage account is frozen, it’s not completely useless. A customer with a frozen account can still perform transactions, but only if the funds are already in the account. Before the customer makes a security purchase, they must have the required cash in their account to pay for the purchase before the trade is placed. Accounts remain frozen for a period of 90 days.
One of the most essential margin formulas to be aware of calculates an account’s equity, which represents the customer’s net ownership value. When investing with borrowed funds, investors must factor in the future repayment of those funds to determine what they own in the account. For example, a $50,000 margin account involving a $20,000 loan to the investor results in $30,000 of equity (the account’s net worth).
We’ll discuss two separate equity formulas in this section:
First, let’s establish the formula to calculate equity in a long account:
LMV stands for long market value, which represents the overall value of all (long/owned) securities held in the account. The debit represents the outstanding loan amount (the amount borrowed and owed back to the broker-dealer). The account equity is found when the debit is subtracted from the LMV. Let’s work through an example:
An investor purchases 100 shares of ABC stock at $50 in their newly-opened margin account and deposits their Regulation T requirement.
Can you determine the equity?
$5,000 (LMV) - $2,500 (debit) = $2,500 (equity)
The investor purchases $5,000 of stock (100 shares x $50) in their margin account. The investor must deposit 50% of the overall purchase or $2,000, whichever is greater. 50% of the initial investment is the greater of the two, so the investor deposits $2,500. The other $2,500 is borrowed from the broker-dealer, which is reflected in the debit.
Let’s try another example:
An investor purchases 200 shares of ABC stock at $70 in their newly opened margin account and deposits their Regulation T requirement. The market then rises to $80. What is the equity?
Can you figure it out?
Answer = $9,000
First, let’s establish how the account starts:
$14,000 (LMV) - $7,000 (debit) = $7,000 (equity)
The investor purchases $14,000 of stock (200 shares x $70) in their margin account. The investor must deposit 50% of the overall purchase or $2,000, whichever is greater. 50% of the overall purchase is the greater of the two, so the investor deposits $7,000. The other $7,000 is borrowed from the broker-dealer, which is reflected in the debit.
Next, let’s factor in the increase in market price to $80 per share:
$16,000 (LMV) - $7,000 (debit) = $9,000 (equity)
Now, the investor holds 200 shares at $80 per share, resulting in an overall LMV of $16,000. The debit does not change because the investor did not borrow more or pay any borrowed funds back, leading to a new equity of $9,000.
In addition to understanding the equity formula for initial purchases in a long margin account, you should also know when formula variables change. Let’s look at this example:
A client of yours goes long 400 shares of ZZZ stock at $20 per share. The stock rises to $30, and the investor sells 100 shares. What is the resulting equity formula?
Here’s a clue to answer this question: unless otherwise stated, any sales proceeds in a long account are used to pay back borrowed funds, effectively reducing the debit balance. Can you take it from here?
First, let’s establish how the account starts:
$8,000 (LMV) - $4,000 (debit) = $4,000 (equity)
The investor purchases $8,000 of stock (400 shares x $20) in their margin account. The investor must deposit 50% of the overall purchase or $2,000, whichever is greater. 50% of the overall purchase is the greater of the two, so the investor deposits $4,000. The other $4,000 is borrowed from the broker-dealer, which is reflected in the debit.
Next, let’s factor in the increase in market price to $30 per share:
$12,000 (LMV) - $4,000 (debit) = $8,000 (equity)
Now, the investor holds 400 shares at $30 per share, resulting in an overall LMV of $12,000. The debit does not change because the investor did not borrow more or pay any borrowed funds back, leading to a new equity of $8,000.
Last, the investor sells 100 shares at $30. When this occurs, this is the resulting equity formula:
$9,000 (LMV) - $1,000 (debit) = $8,000 (equity)
Two figures decline when a security is sold in a long margin account. First, the LMV falls because the account has $3,000 (100 shares x $30) less stock. Those proceeds are used to repay borrowed funds (unless otherwise stated). When this occurs, the debit balance falls by the dollar amount of stock sold. Remember, the debit balance represents the customer’s outstanding loan from the broker-dealer. If they repay $3,000, the debit balance will fall by that amount.
The equity amount is worth noting, which did not change when the investor sold shares. The sale of shares did not increase or decrease the equity ($8,000 before and after the sale). The investor transfers $3,000 of stock to $3,000 of cash, which doesn’t influence the equity. The mere act of buying or selling securities does not affect the account’s net value.
The same idea of equity applies to a short account, but the formula is a bit different:
The credit represents cash held in a margin account, which comes from two different places. First, a short sale involves selling borrowed securities, which puts cash in the account. Second, the investor deposits a certain amount of money (usually 50%) when creating the short position. The combination of those two cash inflows equals the credit. SMV stands for short market value, which is the overall value of the short securities in the account.
Given the difficulty with the short equity formula, let’s walk through an example together:
An investor sells short 100 shares of XYZ stock at $80 and deposits the required margin.
First, let’s find the credit. The credit equals the amount being sold short (100 shares x $80 = $8,000) plus the amount deposited by the investor. Similar to a long account, the investor must deposit the greater of 50% or $2,000. 50% of $8,000 is $4,000, so that’s what the investor deposits. The combination of the amount sold short ($8,000) and the customer’s deposit ($4,000) leads to the credit balance, which is $12,000*.
*The credit balance represents cash “sitting on the sideline.” Investors must repurchase the stock they sell short, so broker-dealers require their investors to have cash in the account to make the required repurchase in the future. In this scenario, the investor has $12,000 in cash waiting to repurchase the 100 shares.
Next is the SMV. The SMV represents the overall short position of $8,000 (100 shares x $80). Now we can do the formula:
$12,000 (credit) - $8,000 (SMV) = $4,000 (equity)
Let’s see if you can do one on your own:
An investor sells short 300 shares of BCD stock at $60 and deposits the required margin. The stock then falls to $50. What is the equity?
Answer = $12,000*
First, let’s establish how the account starts:
$27,000 (credit) - $18,000 (SMV) = $9,000 (equity)
The credit equals the amount being sold short (300 shares x $60 = $18,000) plus the amount deposited by the investor. The investor must deposit the greater of 50% or $2,000. 50% of $18,000 is $9,000, so that’s what the investor deposits. The combination of the amount sold short ($18,000) and the customer’s deposit ($9,000) leads to the credit balance, which is $27,000.
Next, let’s factor in the market price decrease:
$27,000 (credit) - $15,000 (SMV) = $12,000 (equity)
Now, the investor is short 300 shares at $50 per share, resulting in an overall SMV of $15,000. The credit does not change because the investor did not sell short more stock or repurchase shares to close the short position, leading to a new equity of $12,000.
In addition to understanding the equity formula for initial sales in a short margin account, you should also know when formula variables change. Let’s look at this example:
A client of yours goes short 100 shares of CDE stock at $200 per share. The stock falls to $150, and the investor buys back 50 shares to close part of the position. What is the resulting equity formula?
Here’s a clue to answer this question: unless otherwise stated, any repurchase of shares to close a short position is funded with the credit balance. Remember, the credit balance represents cash waiting to be used to buy back shares. Can you take it from here?
$30,000 (credit) - $20,000 (SMV) = $10,000 (equity)
The credit equals the amount being sold short (100 shares x $200 = $20,000) plus the amount deposited by the investor. The investor must deposit the greater of 50% or $2,000. 50% of $20,000 is $10,000, so that’s what the investor deposits. The combination of the amount sold short ($20,000) and the customer’s deposit ($10,000) leads to the credit balance, which is $30,000.
Next, let’s factor in the market price decrease:
$30,000 (credit) - $15,000 (SMV) = $15,000 (equity)
Now, the investor is short 100 shares at $150 per share, resulting in an overall SMV of $15,000. The credit does not change because the investor did not sell short more stock or repurchase shares to close the short position, leading to a new equity of $15,000.
Last, the investor buys back 50 shares at $150. When this occurs, this is the resulting equity formula:
$22,500 (credit) - $7,500 (SMV) = $15,000 (equity)
Two figures decline in the equity formula when a short position is closed. The credit balance decreases because that’s where the $7,500 cash comes from to repurchase the shares (50 shares x $150). The SMV also fell by $7,500 because half of the position was closed.
The equity amount is worth noting, which did not change when the investor bought back shares. Buying back shares did not increase or decrease the equity ($15,000 before and after the sale). The investor transfers $7,500 of cash (credit balance) to close $7,500 of the short position, which doesn’t influence the equity. The mere act of buying or selling securities does not affect the overall value of an account.
This video summarizes the important concepts related to margin equity:
Sign up for free to take 16 quiz questions on this topic