SMA
This section covers the most difficult concepts about margin and typically is not heavily tested. You should attempt to understand and build knowledge in this chapter, but do not spend significant amounts of time attempting to master this material.
When margin accounts gain value, they also gain additional buying power (for long accounts) or selling power (for short accounts). In plain terms, this means the investor can buy or sell short more shares without making additional cash deposits. When a margin account gains value, it also gains something called special memorandum account (SMA).
You’ll want to think of SMA as a credit line on a credit card. The more a person uses a credit card and pays off their balance regularly, the more the credit card company is willing to increase the customer’s credit line (how much they can borrow). SMA in margin accounts works the same way - the more account value gained, the more securities that can be traded without additional deposits of capital.
SMA for long accounts
To understand how to calculate SMA, let’s go through an example of a test question you could see:
An investor purchases 100 shares of stock at $80 and deposits the Regulation T requirement. The stock rises to $120 per share. What is the buying power in the account?
First, let’s do the equity formula based on the initial purchase:
$8,000 (LMV) - $4,000 (debit) = $4,000 (equity)
The investor purchases $8,000 of stock (100 shares x $80) 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 adjust the equity formula to reflect the increase in market value to $120 per share:
$12,000 (LMV) - $4,000 (debit) = $8,000 (equity)
Let’s even calculate the equity in percent form (although this is not necessary to answer the question):
Equity % = $8,000 (equity) / $12,000 (LMV) Equity % = 66.7%
The account is in good shape and well above the initial 50% equity it started at. This account has excess equity, which is the amount of equity above 50%. To find the excess equity in dollar form, use this formula:
Let’s do the formula:
Excess equity = $8,000 (equity) - $6,000 (50% of LMV)
Excess equity = $2,000
In most cases, excess equity and SMA are the same (we’ll discuss when this is not the case later in this section). This is true for this example; the SMA in the account is $2,000. Going back to our original analogy, SMA is like a credit line on a margin account. In this example, the investor can borrow $2,000 of cash from the broker-dealer without depositing any new money. In practice, an SMA level of $2,000 allows the investor to do one of two things:
- Buy $4,000 of new stock without depositing any new money
- Withdraw $2,000 of cash from the account for any purpose
It might be difficult to comprehend, but if someone handed you $2,000, you could effectively purchase $4,000 of securities in a margin account (50% margin requirement). This is how SMA works when purchasing new shares. This is known as buying power, which is twice the amount of SMA in a customer’s account. To see this in practice, let’s go back to our example:
$12,000 (LMV) - $4,000 (debit) = $8,000 (equity)
SMA = $2,000
Now, let’s assume the investor uses all their SMA to purchase $4,000 of new stock without making a new deposit. What happens to the equity formula?
Can you figure it out?
$16,000 (LMV) - $8,000 (debit) = $8,000 (equity)
With an SMA level of $2,000, the investor can borrow $4,000 to purchase new stock in the account. This results in the LMV increasing by $4,000 to $16,000. Additionally, the debit increases by the same amount to $8,000. The investor is borrowing every dollar to make the purchase, which is why the debit increases by $4,000. The amount of equity in dollars ($8,000) stays the same, but the equity in percent will change:
Equity % = $8,000 (equity) / $16,000 (LMV) Equity % = 50%
Utilizing SMA brought the equity percentage from 66.7% down to 50%. This is typical when investors utilize all the SMA in their accounts. It brings their equity level back down to its original starting point (50%).
The investor can also take SMA as cash and use it for any purpose. Some investors use their margin accounts to borrow funds for car purchases, boat purchases, or even home purchases. Instead of going through the process of applying for a loan through a bank, investors can use stock in their margin accounts as collateral for an any-purpose loan. Once the account is set up, no additional paperwork is required, making it easy for investors with high equity levels to borrow. To better understand this, let’s re-establish our original position with SMA:
$12,000 (LMV) - $4,000 (debit) = $8,000 (equity)
SMA = $2,000
An SMA level of $2,000 allows the investor to withdraw up to $2,000 from their account for any purpose. If this were to occur, what happens to the equity?
$12,000 (LMV) - $6,000 (debit) = $6,000 (equity)
The stock value doesn’t change, leaving the LMV at the same level. The debit increases by $2,000 to $6,000 given they’re borrowing the funds. The amount of equity in dollars goes down because they’re taking money out of the account. Now, let’s do the equity formula as a percent:
Equity % = $6,000 (equity) / $12,000 (LMV) Equity % = 50%
Utilizing SMA brought the equity percentage from 66.7% down to 50%. Again, this is typical when investors utilize all the SMA in their accounts. It brings their equity level back down to its original starting point (50%).
SMA serves as a margin account’s credit line. The more the account value increases, the more SMA they create. We established how to calculate SMA with the excess equity formula (above), but SMA can also be calculated in a different way. For every $1 the LMV increases, the SMA increases by $0.50.
With that being said, let’s see if you can make your way through an SMA-related question on your own.
An investor purchases 200 shares of stock at $150 per share in their margin account and makes the required Reg T deposit. The market price rises to $190 per share. Answer these questions:
What is the equity (in $ and %)?
What is the excess equity / SMA?
What is the buying power?
How much may they withdraw in cash?
How far can you get?
$30,000 (LMV) - $15,000 (debit) = $15,000 (equity)
The investor purchases $30,000 of stock (200 shares x $150) 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 $15,000. The other $15,000 is borrowed from the broker-dealer, which is reflected in the debit.
Now, let’s calculate the new equity formula after the market price increase:
$38,000 (LMV) - $15,000 (debit) = $23,000 (equity)
The investor now has 150 shares at $190 per share, resulting in an LMV of $38,000. The investor did not borrow more or pay back borrowed funds, so the debit stays the same. The new equity is $23,000.
Next, let’s calculate the equity as a percent:
Equity % = $23,000 (equity) / $38,000 (LMV) Equity % = 60.5%
And now we’ll calculate excess equity / SMA. There are two ways to do this. First, the excess equity formula:
Excess equity = $23,000 (equity) - $19,000 (50% of LMV)
Excess equity = $4,000
You can also calculate SMA by using this: for every $1 the LMV increases, the SMA increases by $0.50. The LMV went up by $8,000, so the SMA went up by $4,000. Both ways are valid approaches.
Last, we need to evaluate what SMA tells us. Buying power is twice SMA, so the investor could purchase $8,000 of new stock without making any additional deposits. Alternatively, they could withdraw SMA as cash in its full amount, resulting in a disbursement of $4,000.
In each example we went through, excess equity and SMA were the same. This will be true in most margin questions, but it’s possible the two numbers diverge. If a long account were to continually rise, the two figures would always be the same. However, something interesting occurs when the market value falls after gaining excess equity and SMA. Excess equity will fall, but SMA holds its value. SMA is only lost if it’s used, which occurs when buying power is utilized or withdrawing SMA as cash.
SMA is sometimes referred to as a margin account’s “high water mark.” When an investor’s LMV goes up, they create SMA. However, they do not lose it if the market value comes back down. The system is set up this way to allow margin investors to keep their buying power even in a bear market. Otherwise, margin investors may invest less in market downturns. In plain terms, this provides an incentive for margin investors to keep investing in bad times, which may influence market values upward. Investors can utilize their SMA at any time unless it pushes their equity level below minimum maintenance (25%).
SMA for short accounts
The concept and approach to SMA are relatively the same with short accounts. Let’s go through an example:
An investor sells short 400 shares of stock at $50 and deposits the Regulation T requirement. The stock falls to $35 per share. What is the selling power in the account?
*Instead of buying power, we refer to it as selling power with short accounts. The idea is the same, though. Selling power equals the amount of new stock that can be sold short without depositing more money.
First, let’s do the equity formula based on the initial purchase:
$30,000 (credit) - $20,000 (SMV) = $10,000 (equity)
The credit is equal to the amount being sold short (400 shares x $50 = $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 adjust the equity formula to reflect the decrease in market value to $35 per share:
$30,000 (credit) - $14,000 (SMV) = $16,000 (equity)
When the market falls, so does the SMV. Now the investor holds 400 shares at $35 per share, resulting in an overall SMV of $14,000. The credit does not change because the investor did not sell short more stock or purchase shares to close the short position. This leads to a new equity of $16,000.
Let’s even calculate the equity in percent form:
Equity % = $16,000 (equity) / $14,000 (SMV) Equity % = 114.3%
Equity can go above 100% with short accounts (although it does not with long accounts). At an equity level of 114%, this account is in great shape. This account has excess equity, which is the amount of equity above 50%. To find the excess equity in dollar form, use this formula:
Let’s do the formula:
Excess equity = $16,000 (equity) - $7,000 (50% of SMV)
Excess equity = $9,000
In most cases, excess equity and SMA are the same things (but they can be different as we discussed above). This is true for this example; the SMA in the account is $9,000. The investor can borrow $9,000 of cash from the broker-dealer without depositing any new money. In practice, an SMA level of $9,000 in a short account allows the investor to do one of two things:
- Sell short $18,000 of new stock without depositing any new money
- Withdraw $9,000 of cash from the account for any purpose
Selling power is twice the amount of SMA in a customer’s short account, so the answer to the original selling power question is $18,000. To see this in practice, let’s go through an example. First, let’s re-establish these figures:
$30,000 (credit) - $14,000 (SMV) = $16,000 (equity)
SMA = $9,000
Now, let’s assume the investor uses all their SMA to sell short $18,000 of new stock without making a new deposit. What happens to the equity formula?
Can you figure it out?
$48,000 (credit) - $32,000 (SMV) = $16,000 (equity)
With an SMA level of $9,000, the investor can borrow $18,000 to sell short new stock in the account. This results in the SMV increasing by $18,000 to $32,000. Additionally, the credit increases by the same amount to $48,000. The investor receives $18,000 when selling the new shares short, which is why the credit increases by $18,000. The amount of equity in dollars ($16,000) stays the same, but the equity in percent will change:
Equity % = $16,000 (equity) / $32,000 (SMV) Equity % = 50%
Utilizing SMA brought the equity percentage from 114% down to 50%. This is typical when investors utilize all the SMA in their accounts. It brings their equity level back down to its original starting point (50%).
The investor can also take SMA as cash and use it for any purpose. To better understand this, let’s re-establish our original position with SMA:
$30,000 (credit) - $14,000 (SMV) = $16,000 (equity)
SMA = $9,000
An SMA level of $9,000 allows the investor to withdraw up to $9,000 from their account for any purpose. If this were to occur, what happens to the equity?
$21,000 (credit) - $14,000 (SMV) = $7,000 (equity)
The stock value doesn’t change, leaving the SMV at the same level. The credit decreases by $9,000 to $21,000 given they’re borrowing the funds (the cash comes from the credit balance). The amount of equity in dollars goes down because they’re taking money out of the account. Now, let’s do the equity formula as a percent:
Equity % = $7,000 (equity) / $14,000 (SMV) Equity % = 50%
Utilizing SMA brought the equity percentage from 114% down to 50%. Again, this is typical when investors utilize all the SMA in their accounts. It brings their equity level back down to its original starting point (50%).
SMA serves as a margin account’s credit line. The more the short account value decreases, the more SMA they create. We established how to calculate SMA with the excess equity formula (above), but SMA can also be calculated in a different way. For every $1 the SMV decreases, the SMA increases by $1.50.
With that being said, let’s see if you can make your way through an SMA-related question on your own.
An investor sells short 200 shares of stock at $60 per share in their margin account and makes the required Reg T deposit. The market price falls to $40 per share. Answer these questions:
What is the equity (in $ and %)?
What is the excess equity / SMA?
What is the buying power?
How much may they withdraw in cash?
How far can you get?
$18,000 (credit) - $12,000 (SMV) = $6,000 (equity)
The credit is equal to the amount being sold short (200 shares x $60 = $12,000) plus the amount deposited by the investor. The investor must deposit the greater of 50% or $2,000. 50% of $12,000 is $6,000, so that’s what the investor deposits. The combination of the amount sold short ($12,000) and the customer’s deposit ($6,000) leads to the credit balance, which is $18,000. Next, let’s adjust the equity formula to reflect the decrease in market value to $40 per share:
$18,000 (credit) - $8,000 (SMV) = $10,000 (equity)
When the market falls, so does the SMV. Now the investor holds 200 shares at $40 per share, resulting in an overall SMV of $8,000. The credit does not change because the investor did not sell short more stock or purchase any shares to close the short position. This leads to a new equity of $10,000.
Next, let’s calculate the equity as a percent:
Equity % = $10,000 (equity) / $8,000 (SMV)
Equity % = 125%
And now we should calculate excess equity / SMA. There are two ways to do this. First, the excess equity formula:
Excess equity = $10,000 (equity) - $4,000 (50% of SMV)
Excess equity = $6,000
You can also calculate SMA by using this: for every $1 the SMV decreases, the SMA increases by $1.50. The SMV went down by $4,000, so the SMA went up by $6,000. Both ways are valid approaches.
Last, we need to evaluate what SMA tells us. Selling power is twice SMA, so the investor could sell short $12,000 of new stock without making any additional deposits. Alternatively, they could withdraw SMA as cash in its full amount, resulting in a disbursement of $6,000.
Similar to a long account, SMA is a “high water mark” in a short account. SMA is gained as the SMV goes down, but is not lost if the SMV goes back up. SMA is only lost if it’s used, which occurs when selling power is utilized or withdrawing SMA as cash. Investors can utilize their SMA at any time unless it pushes their equity level below minimum maintenance (30%).
Sign up for free to take 5 quiz questions on this topic