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. They also prohibit strategies with unlimited loss potential, such as short-selling securities.
Margin accounts allow investors to borrow money for investment purposes and permit higher-risk strategies. 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 magnifies both gains and losses. With a margin account, you can earn more when an investment goes your way, 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, which is more than you could’ve made with only your $5,000. If you lose, you lose not only your $5,000, but also your friend’s $5,000 that you still owe back.
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 accounts add risk, they’re generally suitable only 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 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 the loan, the broker-dealer can liquidate (sell) securities in the account to satisfy the debt.
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 takes the borrowed money from the bank and lends it to customers at a slightly higher interest rate. The difference between:
is how broker-dealers earn revenue from margin lending.
The credit agreement contains the terms of the margin loan. This is where you’ll find how the broker-dealer calculates margin interest, the repayment terms, and other loan conditions.
The final part of the margin agreement is the loan consent form. If a customer signs it, they allow the broker-dealer to lend their securities to other customers for short sales. If you recall, short sales involve borrowing securities from a broker-dealer, selling them, and (ideally) buying them back after the price drops. The borrowed securities come from other margin customers. This happens behind the scenes; margin customers typically won’t know when their securities are being borrowed.
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 alongside (or within) other customer positions. 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 the customer is not required to sign. 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. It requires investors to make a 50% deposit when borrowing money or securities for investment purposes. The Federal Reserve administers this rule. In most margin transactions, the initial deposit is 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 loans. 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.
Therefore, the investor must deposit $2,000.
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 if the maximum loss is $1,200 (assuming the stock becomes worthless). In that case, the investor must deposit 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 significantly. 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 a total of $2,000. Unlike long positions, short positions 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 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 by Regulation T settlement, the broker-dealer must take action. The firm can either:
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’ll have a few additional days to deposit the $10,000. Extension requests are relatively uncommon and may be denied.
More commonly, the firm liquidates positions and freezes the account. Using the same example, if the customer still owes $10,000 at Regulation T settlement (two business days after regular-way settlement), the firm may liquidate $10,000 of securities in the account, apply the proceeds to the obligation, and then freeze the account.
A frozen account can still be used, but only on a fully paid basis. Before placing a purchase, the customer must already have enough cash in the account to pay for it. The freeze lasts for 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. For example, if a margin account has $50,000 of securities and a $20,000 loan balance, the equity is $30,000.
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.
So the investor deposits $2,500 and borrows the remaining $2,500. The borrowed amount is the debit.
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, the account at purchase:
$14,000 (LMV) - $7,000 (debit) = $7,000 (equity)
The investor purchases $14,000 of stock (200 shares x $70). The required deposit is the greater of 50% or $2,000.
So the investor deposits $7,000 and borrows $7,000 (the debit).
Next, after the market rises to $80:
$16,000 (LMV) - $7,000 (debit) = $9,000 (equity)
LMV increases because the stock is worth more. The debit stays the same 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 otherwise stated, sales proceeds in a long margin account are used to repay the loan, which reduces the debit balance.
First, at purchase:
$8,000 (LMV) - $4,000 (debit) = $4,000 (equity)
The investor purchases $8,000 of stock (400 shares x $20). The required deposit is the greater of 50% or $2,000.
So the investor deposits $4,000 and borrows $4,000.
Next, after the stock rises to $30:
$12,000 (LMV) - $4,000 (debit) = $8,000 (equity)
LMV increases with the market price. The debit stays the same.
Last, the investor sells 100 shares at $30:
$9,000 (LMV) - $1,000 (debit) = $8,000 (equity)
Two values drop when shares are sold in a long margin account:
Notice that equity doesn’t change. Selling converts $3,000 of stock into $3,000 of cash and uses that cash to reduce the loan. The act of buying or selling, by itself, doesn’t change the account’s net value.
Equity in a short account follows the same idea (net ownership value), but the formula is different:
The credit comes from two sources:
Because the short equity formula can feel 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 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 SMV:
Now apply the formula:
$12,000 (credit) - $8,000 (SMV) = $4,000 (equity)
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, at the start:
$27,000 (credit) - $18,000 (SMV) = $9,000 (equity)
Credit = $18,000 + $9,000 = $27,000.
Next, after the stock falls to $50:
$27,000 (credit) - $15,000 (SMV) = $12,000 (equity)
SMV falls because the stock price fell. The credit stays the same because the investor didn’t short more shares or buy shares back.
You also need to know how the variables change when part of a short position is closed.
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 otherwise stated, repurchases to close a short position are paid for using the credit balance.
First, at the start:
$30,000 (credit) - $20,000 (SMV) = $10,000 (equity)
Credit = $20,000 + $10,000 = $30,000.
Next, after the stock falls to $150:
$30,000 (credit) - $15,000 (SMV) = $15,000 (equity)
SMV falls with the market price. The credit stays the same.
Last, the investor buys back 50 shares at $150:
$22,500 (credit) - $7,500 (SMV) = $15,000 (equity)
Two values drop when part of a short position is closed:
Notice that equity doesn’t change. The investor uses $7,500 of cash to eliminate $7,500 of short market value. Buying or selling, by itself, doesn’t change the account’s net value.
This video summarizes the important concepts related to margin equity:
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