At brokerage firms, there are two main types of accounts: cash and margin accounts. Cash accounts require investors to pay 100% for each securities transaction and prohibit strategies with unlimited loss potential, such as short selling. Margin accounts allow investors to borrow money for investment purposes and permit higher-risk 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’re using leverage. Leverage magnifies both gains and losses. With a margin account, you can earn more when your investment is right, but you can also lose more when the market moves against you.
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 on one game. If you win, you double your money to $20,000 - more than you could’ve made with only your $5,000. If you lose, you lose your $5,000 and you still owe your friend $5,000.
Borrowing money to invest works the same way. You can increase returns if you’re right, but you can also increase losses if you’re wrong. Because margin adds risk, it’s generally only appropriate for investors who can tolerate significant losses.
In this chapter, we’ll cover how margin accounts work, the regulations that govern them, and how investors use them.
Margin accounts require more than a basic new account form. Customers opening margin accounts must complete and sign the margin agreement, which has three parts: the hypothecation agreement, credit agreement, and loan consent form.
The hypothecation agreement requires the customer to pledge their securities as collateral for margin loans. Just as a home serves as collateral for a mortgage, securities held in a brokerage account serve as collateral for a margin loan. If a customer borrows money from their broker-dealer and can’t repay it, the broker-dealer can liquidate (sell) securities in the account to satisfy the loan.
Broker-dealers are not banks and typically don’t have large amounts of cash available to lend. Instead, they rehypothecate (re-pledge) customers’ securities to banks in exchange 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 customer’s loan amount. 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.
The broker-dealer then lends the bank’s money to customers at a slightly higher interest rate. The difference between the interest rate the broker-dealer pays the bank (the broker loan rate) and the interest rate charged to customers is how broker-dealers earn revenue from margin lending.
The credit agreement contains the margin loan terms. This is where you’ll find how the broker-dealer calculates margin interest, the repayment schedule, and other loan conditions.
The final part of the margin agreement is the loan consent form. If a customer signs it, they authorize the broker-dealer to lend their securities to other customers for short sales. As a reminder, short sales involve borrowing securities from a broker-dealer, selling them, and (ideally) buying them back after the price drops. The borrowed securities typically come from other margin customers. This happens behind the scenes; margin customers generally won’t know when their securities are being lent.
When a customer has a loan consent form on file, their securities may be commingled with other customers’ securities. That means their stocks, bonds, and other investments may be held in other customer accounts. This is not permitted in cash accounts: fully paid securities 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 that is optional. By law, the hypothecation agreement and credit agreement must be signed to open a margin account.
Deposit requirements are the amount of money required to execute an investment strategy in a margin account. When borrowing money from a broker-dealer, investors are subject to Regulation T and FINRA requirements.
Regulation T is a rule under the Securities Exchange Act of 1934 that generally requires a 50% deposit when borrowing money or securities for investment purposes. The Federal Reserve administers this rule. In typical margin transactions, the investor deposits 50% of the transaction value.
Sometimes the required deposit is more than 50%. FINRA requires a minimum margin equity (ownership) level of $2,000 to use margin. In practice, the required deposit is the greater of the Regulation T requirement and the FINRA requirement.
Let’s work through an example.
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, suppose an investor purchases $1,200 of a security. Requiring a $2,000 deposit wouldn’t make sense when the maximum loss is $1,200 (assuming the stock becomes worthless). In that case, the investor deposits 100% of the purchase amount. Practically, the account is treated like a cash account for that transaction.
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 differ for short accounts. When an investor sells short stock, losses can exceed the initial value of the position. For example, assume an investor shorts 100 shares at $15. The initial short position is $1,500, but the investor could lose an unlimited amount if the stock rises. If the stock price rises to $50, the investor must spend $5,000 to buy it back ($50 x 100 shares), resulting in a $3,500 loss ($1,500 short sale - $5,000 repurchase).
Because short positions have higher risk, margin rules require a minimum deposit equal to the greater of 50% or $2,000. Most importantly, even a small short position below $2,000 still requires 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 $2,000. Unlike long purchases, short sales below $2,000 still require at least a $2,000 deposit. If this example were a long purchase of 10 shares at $40, the required deposit would be only $400.
Regulation T also sets a payment/delivery deadline for both margin and cash accounts. Although different securities have different settlement times, Regulation T settlement is always two business days after regular-way settlement. This is the last day cash for a purchase or securities for a sale can be delivered.
If an investor doesn’t deposit the required cash or securities by Regulation T settlement, the broker-dealer must take action. The firm can request an extension from the appropriate SRO (usually FINRA), or it can close out the position and freeze the account.
If the firm obtains an extension, the customer gets a few extra days to meet the obligation. For example, if a customer owes $10,000 for a recent purchase, they may receive a few additional days to deposit the $10,000. Extensions are relatively uncommon and may be denied.
More commonly, the firm liquidates positions as needed and freezes the account. Using the same example, if the customer owes $10,000 and doesn’t pay by Regulation T settlement (two business days after regular settlement), the firm can liquidate $10,000 of securities in the account. The firm applies the proceeds to the obligation and then freezes the account.
A frozen account isn’t completely unusable. The customer can still trade, but only if the funds are already in the account. In other words, the customer must have the required cash on deposit before placing a purchase order. The freeze lasts 90 days.
A key margin concept is equity, which is the customer’s net ownership value in the account. When borrowed funds are involved, you have to account for the loan that must be repaid to determine what the customer truly owns. For example, a $50,000 margin account with a $20,000 loan has $30,000 of equity.
We’ll use two equity formulas:
Here’s the equity formula for a long margin account:
Equity is what remains after subtracting the debit from the LMV.
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). The investor must deposit the greater of 50% of the purchase or $2,000. Here, 50% is greater, so the investor deposits $2,500. The remaining $2,500 is borrowed from the broker-dealer, which becomes 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, here’s how the account starts:
$14,000 (LMV) - $7,000 (debit) = $7,000 (equity)
The investor purchases $14,000 of stock (200 shares x $70). The investor deposits 50% (which is greater than $2,000), so they deposit $7,000. The other $7,000 is borrowed, creating a $7,000 debit.
Next, incorporate the price increase to $80:
$16,000 (LMV) - $7,000 (debit) = $9,000 (equity)
The LMV rises because the stock is now worth $16,000 (200 x $80). The debit doesn’t change because the investor didn’t borrow more or repay the loan.
You also need to know when the variables change. Consider 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 the key rule: unless stated otherwise, sale proceeds in a long margin account are used to repay the margin loan, which reduces the debit balance.
First, here’s how the account starts:
$8,000 (LMV) - $4,000 (debit) = $4,000 (equity)
The investor buys $8,000 of stock (400 x $20). They deposit 50% (greater than $2,000), so they deposit $4,000 and borrow $4,000.
Next, incorporate the price increase to $30:
$12,000 (LMV) - $4,000 (debit) = $8,000 (equity)
The LMV increases to $12,000 (400 x $30). The debit stays at $4,000.
Finally, the investor sells 100 shares at $30. The updated formula is:
$9,000 (LMV) - $1,000 (debit) = $8,000 (equity)
Two values change when shares are sold in a long margin account:
Notice that equity doesn’t change from the sale itself ($8,000 before and after). Selling converts $3,000 of stock into $3,000 of cash, so the account’s net value is unchanged.
Equity works the same way in a short account, but the formula is different:
Because this formula is less intuitive, let’s walk through an example.
An investor sells short 100 shares of XYZ stock at $80 and deposits the required margin.
First, find the credit:
So the credit balance is $8,000 + $4,000 = $12,000*.
*The credit balance represents cash “on the sideline.” Since the investor must eventually repurchase the stock, the broker-dealer requires cash in the account to support that future buy-in. In this example, $12,000 is available to repurchase the 100 shares.
Next, find the SMV:
Now apply the formula:
$12,000 (credit) - $8,000 (SMV) = $4,000 (equity)
Now try 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, here’s how the account starts:
$27,000 (credit) - $18,000 (SMV) = $9,000 (equity)
The credit equals the short sale proceeds plus the deposit:
So credit = $18,000 + $9,000 = $27,000.
Next, incorporate the price decrease to $50:
$27,000 (credit) - $15,000 (SMV) = $12,000 (equity)
The SMV falls to $15,000 (300 x $50). The credit doesn’t change because the investor hasn’t shorted more shares or repurchased any shares.
You also need to know when the variables change in a short account. Consider 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?
Key rule: unless stated otherwise, repurchases to close a short position are funded from the credit balance (the cash set aside to buy back shares).
$30,000 (credit) - $20,000 (SMV) = $10,000 (equity)
The credit equals the short sale proceeds plus the deposit:
So credit = $20,000 + $10,000 = $30,000.
Next, incorporate the price decrease to $150:
$30,000 (credit) - $15,000 (SMV) = $15,000 (equity)
The SMV falls to $15,000 (100 x $150). The credit doesn’t change.
Finally, the investor buys back 50 shares at $150. The updated formula is:
$22,500 (credit) - $7,500 (SMV) = $15,000 (equity)
Two values decline when part of a short position is closed:
Notice that equity doesn’t change from the act of buying back shares ($15,000 before and after). The account is simply using $7,500 of cash to eliminate $7,500 of short exposure.
This video summarizes the important concepts related to margin equity:
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