Minimum maintenance

This chapter covers a lot of detail that’s usually tested lightly. While any of it could appear on the exam, it’s uncommon to see more than one or two questions focused on margin. Plan your study time accordingly, and don’t overinvest effort in memorizing every calculation.

Minimum maintenance

Margin accounts increase the normal risks of investing. If an investor buys shares in a margin account and those shares lose 100% of their value, the investor loses the value of the shares and still must repay the borrowed funds. That’s leverage: it increases both potential gains and potential losses.

Minimum maintenance requirements are designed to keep margin accounts from becoming dangerously undercollateralized when the market moves against the investor. They also protect the broker-dealer from being left with unpaid debt (or, in a short account, an unwanted short position). This section covers minimum maintenance for both long and short margin accounts.

Minimum maintenance for long accounts

You’ll see several numbers and calculations in this section. The Series 65 rarely asks calculation-heavy questions, but it may test the concepts behind them. Focus on what the numbers mean rather than memorizing the math.

To work with minimum maintenance, it helps to use a percentage form of the equity formula:

$$\text{Equity \%}=\frac{\text{Equity (in \$)}}{\text{LMV or SMV}}$$

Let’s assume an investor buys 200 shares at $30 per share and deposits the required initial margin. The standard equity formula (in dollars) is:

$6,000 (LMV) - $3,000 (debit) = $3,000 (equity)

Now calculate equity as a percentage:

Equity % = $3,000 (equity) / $6,000 (LMV) Equity % = 50%

That 50% makes sense: the investor owns $3,000 of a $6,000 position.

Market value changes will change the equity percentage. Here’s an example.

An investor purchases 200 shares of ABC stock at $300 and deposits the required margin. The market price then falls to $175. What is the equity amount in dollars and percent?

Start with the account at purchase:

$60,000 (LMV) - $30,000 (debit) = $30,000 (equity)

The investor buys $60,000 of stock (200 × $300). The initial margin deposit is 50% of the purchase price (or $2,000, whichever is greater). Here, 50% is greater, so the investor deposits $30,000 and borrows the other $30,000 (the debit).

Now update the LMV after the price drop to $175:

$35,000 (LMV) - $30,000 (debit) = $5,000 (equity)

• LMV falls to $35,000 (200 × $175).
• The debit stays at $30,000 because no loan repayment (or additional borrowing) occurred.
• Equity falls to $5,000.

Now compute the equity percentage:

Equity % = $5,000 (equity) / $35,000 (LMV) Equity % = 14.3%

At 14.3% equity, the account is close to being “underwater” (owing more than the account is worth). If the market keeps falling, the broker-dealer faces a higher risk of not being repaid. To limit that risk, FINRA sets minimum maintenance requirements.

The minimum maintenance for long accounts is 25% equity. If equity falls below 25%, the situation must be corrected. A long margin account below minimum maintenance can be fixed in three ways:

1. Investor deposits more money
2. Investor deposits “fully paid” stock
3. Securities are sold

If the investor deposits cash, that cash is typically used to reduce the debit balance. Reducing the debit increases equity (in both dollars and percent). Using the same low-equity example:

$35,000 (LMV) - $30,000 (debit) = $5,000 (equity)

What would be the resulting equity (in $ and % form) if the investor deposited $10,000?

Can you figure it out?

The investor can also deposit “fully paid” securities. In plain terms, this means transferring securities the investor already owns (often from another account) into the margin account. This increases the account’s market value and provides more collateral for the margin loan.

Return to the low-equity example:

$35,000 (LMV) - $30,000 (debit) = $5,000 (equity)

What would be the resulting equity (in $ and % form) if the investor deposited $15,000 of fully paid stock?

The last remedy is to sell securities. The sale may be initiated by the customer or by the broker-dealer. When the investor signs the margin agreement, the investor gives the broker-dealer the right to sell securities in the account (with or without notice) to protect the firm’s loan.

Use the same low-equity account again:

$35,000 (LMV) - $30,000 (debit) = $5,000 (equity)

What would be the equity (in $ and % form) if the investor (or the broker-dealer) sold $25,000 of stock?

Now let’s look at how to find the market value where a long account hits minimum maintenance. Start with the original purchase:

$60,000 (LMV) - $30,000 (debit) = $30,000 (equity)

To find the market value where the account would be exactly at 25% equity, use:

$$\text{Mkt value at min. maint.}=\frac{\text{Debit}}{\text{0.75}}$$

Apply it:

Mkt value at min. maint. = $30,000 (debit) / 0.75 Mkt value at min. maint. = $40,000

So if LMV falls to $40,000, the account is exactly at 25% equity. You can verify that:

$40,000 (LMV) - $30,000 (debit) = $10,000 (equity)

Equity % = $10,000 (equity) / $40,000 (LMV) Equity % = 25%

This gives a quick way to estimate how far a long margin account can fall before action is required.

Sidenote

Restricted accounts

When an account falls below 50% equity, it becomes restricted. Restricted accounts are less severe than they sound. When equity is below 50%, half of any sales proceeds must be used to pay down the debit balance.

In an unrestricted account, an investor could sell securities and withdraw the cash even with an outstanding debit balance. Once equity drops below 50%, that flexibility is limited by the restriction rule.

Minimum maintenance for short accounts

The same basic idea applies to short accounts: minimum maintenance helps prevent the account from becoming undercollateralized. The key differences are the required percentage and how the account is structured.

Short accounts must maintain at least 30% equity (not 25% as in long accounts). If equity falls below 30%, the investor or broker-dealer must correct the deficiency.

Let’s work through an example.

An investor has an already established margin account with a credit balance of $52,000 and a short market value of $20,000. The account value rises to $45,000. What is the equity amount (in $ and % form)?

First, compute equity in dollars:

$52,000 (credit) - 45,000 (SMV) = $7,000 (equity)

Now compute equity as a percentage:

Equity % = $7,000 (equity) / $45,000 (SMV) Equity % = 15.5%

At 15.5%, the account is below the 30% minimum maintenance requirement. A short account becomes “underwater” if the SMV rises above the credit balance, because the cost to repurchase the shares would exceed the cash in the account.

A short margin account below minimum maintenance can be fixed in two ways:

1. Investor deposits more money
2. Part or all of the short position is closed (repurchased)

Using the low-equity example:

$52,000 (credit) - 45,000 (SMV) = $7,000 (equity)

If the investor deposited $18,000 of cash in the account, what would be the changes to equity (in $ and % form)?

The other fix is to repurchase shares to close part (or all) of the short position. As with long accounts, this may be done by the investor or by the broker-dealer (the [margin agreement gives them the right to do so).

Return to the low-equity example:

$52,000 (credit) - 45,000 (SMV) = $7,000 (equity)

What would the equity change to (in $ and % form) if the investor closed $30,000 of the short position?

As with long accounts, you can use a formula to find the market value where a short account hits minimum maintenance. Re-use the original setup:

An investor has an already established margin account with a credit balance of $52,000 and a short market value of $20,000.

First, compute equity in dollars:

$52,000 (credit) - 20,000 (SMV) = $32,000 (equity)

Now compute equity as a percentage:

Equity % = $32,000 (equity) / $20,000 (SMV) Equity % = 160%

With short accounts, equity can exceed 100%. If the investor is concerned about the SMV rising to the point where the account reaches minimum maintenance, use:

$$\text{Mkt value at min. maint.}=\frac{\text{Credit}}{\text{1.3}}$$

Apply it:

Mkt value at min. maint. = $52,000 (credit) / 1.3 Mkt value at min. maint. = $40,000

So if SMV rises to $40,000, the account is exactly at 30% equity. Verify it:

$52,000 (credit) - $40,000 (SMV) = $12,000 (equity)

Equity % = $12,000 (equity) / $40,000 (SMV) Equity % = 30%

This provides a quick way to estimate how far a short position can move against the investor before action is required.

This video summarizes the important concepts related to minimum maintenance:

Key points

Minimum maintenance for long accounts

• 25% equity requirement
• If falling below, must:
  • Deposit cash
  • Deposit fully paid securities
  • Sell securities

Restricted accounts

• Below 50% equity
• Half of sales proceeds must pay down the debit balance

Minimum maintenance for short accounts

• 30% equity requirement
• If falling below, must:
  • Deposit cash
  • Close short position