Textbook

Margin accounts increase the normal risks of investing. If an investor purchases shares in a margin account and those shares lose 100% of their value, they lose the overall value of those shares, plus have to pay back borrowed funds. That’s leverage in a nutshell; increased gain *and* loss potential.

**Minimum maintenance** helps ensure customer margin accounts don’t spiral out of control if the market moves against them. Additionally, they help protect the broker-dealer offering the margin account from being stuck with unpaid debts or an unwanted short position. In this section, we’ll explore minimum maintenance for long and short accounts.

To understand minimum maintenance, we need to first establish another form of the equity formula:

$Equity %=LMV or SMVEquity (in $) $

Let’s assume an investor purchases 200 shares of stock at $30 per share and deposits the required initial margin. The regular equity formula would look like this:

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

Now, let’s calculate the equity percentage using the new formula we established above:

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

It shouldn’t be a surprise the account is currently at 50% equity. Remember, equity represents the overall amount the investor owns of the margin account. If the investor owns $3,000 of a $6,000 account, they own 50% of the account. Of course, the equity formula (both of them) will change when market values change. Let’s work through an example together:

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?

First, let’s establish how the account starts:

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

The investor purchases $60,000 of stock (200 shares x $300) 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 $30,000. The other $30,000 is borrowed from the broker-dealer, which is reflected in the debit.

Next, let’s factor in the decrease in market price to $175 per share:

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

When the market falls, so does the LMV. Now the investor holds 200 shares at $175 per share, resulting in an overall LMV of $35,000. The debit does not change because the investor did not borrow more money or pay any borrowed funds back. This leads to a new equity of $5,000.

Last, let’s calculate the equity percentage:

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

Whether you realize it or not, the investor is in a really bad position. They lost $25,000 of equity when the market fell and is close to their account going “underwater” (owing more than the account is worth). If the market continues to fall, the broker-dealer is at risk of not being repaid the $30,000 they lent to the customer. To avoid something like this happening, FINRA enforces minimum maintenance rules.

The minimum maintenance for long accounts is **25% equity**. Meaning, the equity percent cannot fall below 25% without the investor or broker-dealer moving to remedy the situation. Broker-dealers issue **margin calls** when an account falls below minimum maintenance requirements, which are formal requests for customers to “fix” their account. There are three ways to resolve minimum maintenance issues in long margin accounts:

- Investor deposits more money
- Investor deposits “fully paid” stock
- Securities are sold

If the investor deposited more money in the margin account, the debit balance would fall and the equity (both in $ and % form) would rise. Let’s demonstrate this using the previous 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?

(spoiler)

First, let’s re-establish the equity formula given the influx of $10,000 into the account:

**$35,000** (LMV) - **$20,000** (debit) = **$15,000** (equity)

Nothing is mentioned about the stock’s market value, so the LMV does not change. Any money deposited into the account will be used to pay back borrowed funds, which brings the debit balance down by $10,000. The new equity amount in dollars is $15,000.

Now, let’s calculate the equity in percent form:

**Equity %** = **$15,000** (equity) / **$35,000** (LMV)
**Equity %** = **42.8%**

With the deposit of $10,000 of cash, the equity percent increased from 14.3% to 42.8%. The account is now above minimum maintenance (25%), putting it “in good standing.”

The investor can also deposit “fully paid” securities into the account to increase their equity. In plain terms, this means moving securities the investor owns (typically from another account) into this account. It increases the amount of stock in the account, which serves as collateral for the margin loan. Let’s go back to our example with low equity figures:

**$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?

(spoiler)

First, let’s the new equity formula in dollars:

**$50,000** (LMV) - **$30,000** (debit) = **$20,000** (equity)

The amount of stock in the account increases by $15,000 to $50,000. The investor isn’t paying back borrowed funds or borrowing more, so the debit balance doesn’t change. The new equity amount in dollars is $20,000.

Now, let’s calculate the equity in percent form:

**Equity %** = **$20,000** (equity) / **$50,000** (LMV)
**Equity %** = **40%**

With the deposit of $15,000 of stock, the equity percent increased from 14.3% to 40%. The account is now above minimum maintenance (25%), putting it “in good standing.”

The last remedy for a long margin account below minimum maintenance is to sell securities. This can be done voluntarily by the customer or proactively by the broker-dealer. When the investor signed the **margin agreement**, they gave the right to the broker-dealer to sell shares in the account at any time, with or without notice. It might sound cruel, but the broker-dealer can sell any security in the customer’s account to pay themselves back the funds they lent. Of course, it’s important for the broker-dealer to maintain a good relationship with their customer, so most firms will only do this as a last resort.

Let’s look at our account with low equity 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?

(spoiler)

**$10,000** (LMV) - **$5,000** (debit) = **$5,000** (equity)

When the stock is sold, the LMV falls by $25,000 with part of the position being closed. Unless otherwise stated, the proceeds are used to pay back borrowed funds, resulting in the debit balance falling by $25,000. The equity in dollar form ($5,000) does not change. Remember, the act of buying or selling does not affect equity (in dollar form).

Now, let’s re-calculate the equity in percent form:

**Equity %** = **$5,000** (equity) / **$10,000** (LMV)
**Equity %** = **50%**

With the sale of $25,000 of stock, the equity percent increased from 14.3% to 50%. The account is now above minimum maintenance (25%), putting it “in good standing.”

We’ve established minimum maintenance and how to deal with an account that falls below requirements. Now, let’s discuss the way to determine how far an account may fall before it’s at minimum maintenance. Let’s use our original example:

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

If the investor was worried about going below the 25% minimum maintenance requirement, they could use this formula:

$Mkt value at min. maint.=0.75Debit $

This formula tells the investor how far the account would have to fall to be exactly at 25% equity. Let’s do the formula using our example:

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

If the market value were to fall to $40,000, the account would be exactly at 25% equity. You can double-check this using the equity formulas we’ve utilized. First, the equity formula in dollars:

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

Next, the equity formula as a percentage:

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

As you can see, the account is exactly at 25% equity when it falls to $40,000. This is a quick way to determine how far an investor can let their long margin account fall before they’ll have to take action in their account.

The same philosophy behind minimum maintenance for long accounts applies to short accounts, but there are some differences in approach. The biggest difference is the amount; short accounts must always maintain at least **30% equity** (not 25% like long accounts). If equity falls below 30%, the investor or broker-dealer must move to remedy the situation. Let’s work through an example together:

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, the equity formula in dollar form:

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

Next, the equity formula in percent form:

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

This account is well below the 30% minimum maintenance requirement. The account is in danger of going “underwater,” which would occur if the market value went above the credit balance. This results in the value of the stock required to be repurchased being more than the cash in the account. There are two ways to fix a short margin account that falls below minimum maintenance:

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

Let’s assume our example with low equity:

**$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)?

(spoiler)

First, let’s look at the changes to the dollar-based equity formula:

**$70,000** (credit) - **45,000** (SMV) = **$25,000** (equity)

Any new cash deposited to the account is placed in the credit balance, increasing it to $70,000. The SMV stays the same because the market value of the short position did not change. This results in a new equity of $25,000.

Now, let’s calculate the new equity in percent form:

**Equity %** = **$25,000** (equity) / **$45,000** (SMV)
**Equity %** = **55.5%**

With the deposit of $18,000 of cash, the equity percent increased from 15.5% to 55.5%. The account is now above minimum maintenance (30%), putting it “in good standing.”

The other fix is to repurchase shares to close part or all of the short positions. Similar to long accounts, the investor may do this voluntarily, or the broker-dealer may do it proactively (the **margin agreement** gives them the right to do so). Let’s refresh and use the original 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?

(spoiler)

First, let’s look at the changes to the dollar-based equity formula:

**$22,000** (credit) - **15,000** (SMV) = **$7,000** (equity)

Closing a short position requires repurchasing the borrowed shares. Cash held in the credit balance is used to do so, which is why it falls by $30,000. Additionally, the SMV falls by $30,000 with a large portion of the position being closed. The equity does not change; remember, buying or selling securities does not affect equity.

Now, let’s calculate the new equity in percent form:

**Equity %** = **$7,000** (equity) / **$15,000** (SMV)
**Equity %** = **46.7%**

With the closing purchase of $30,000 of short stock, the equity percent increased from 15.5% to 46.7%. The account is now above minimum maintenance (30%), putting it “in good standing.”

Similar to long accounts, a formula can be used to determine at what market value the account would reach minimum maintenance. First, let’s re-use our original example:

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

First, let’s look at the dollar-based equity formula:

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

Now, let’s calculate the equity in percent form:

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

Equity can go above 100% with short accounts (although it does not with long accounts). At an equity level of 160%, this account is in great shape. If the investor was worried about reaching minimum maintenance if the SMV were to rise, they can utilize this formula to determine when this would occur:

$Mkt value at min. maint.=1.3Credit $

This formula tells the investor how far the SMV would have to rise to be exactly at 30% equity. Let’s do the formula using our example:

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

If the market value were to rise to $40,000, the account would be exactly at 30% equity. You can double-check this using the equity formulas we’ve utilized. First, the equity formula in dollars:

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

Next, the equity formula as a percent:

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

As you can see, the account is exactly at 30% equity when the SMV rises to $40,000. This is a quick way to determine how far an investor can let their short margin account rise before they’ll have to take action in their account.

This video summarizes the important concepts related to minimum maintenance:

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