Beyond opening margin requirements and understanding minimum deposit requirements, the following margin-related concepts must be known for the exam:
Margin accounts increase the typical risks of investing. If an investor purchases shares in a margin account and those shares lose 100% of their value, the investor loses both:
That’s leverage in a nutshell: it increases both gain and loss potential.
Minimum maintenance helps keep customer margin accounts from becoming undercollateralized when the market moves against the customer. It also helps protect the broker-dealer from being left with unpaid debts or an unwanted short position.
Minimum maintenance is generally only a concern with short (naked) options. When this type of position is established, a customer must maintain equity equal to the greater of:
Most of the time, the initial deposit requirements are the greater amount. When that’s the case, the investor must maintain a minimum equity* level equal to the initial deposit requirements.
*Equity refers to the liquidation value of the account. For example, an investor with a $10,000 stock position and a $6,000 debit (loan) balance maintains a $4,000 equity value. If the $10,000 position were liquidated, the investor would repay the $6,000 loan and walk away with $4,000.
When margin accounts increase in value, they also gain additional buying power (for long accounts) or selling power (for short accounts). In practical terms, the investor may be able to enter new transactions without making additional cash deposits.
When a margin account gains value, it also gains something called a special memorandum account (SMA).
A helpful way to think about SMA is as a credit line. As the account’s value increases, the firm may extend additional credit that can be used to support new purchases (or short sales) without an immediate deposit.
An account’s buying or selling power equals twice the amount of the account’s SMA. Let’s apply that in an example:
A margin account currently maintains an SMA of $2,000. The account holder plans to establish four long ABC Jan 50 calls at $12. What minimum amount must the account holder deposit to establish the position?
Can you figure it out?
Answer = $800
Long options require a payment of 100% of the option premium to be established. The account holder is purchasing $4,800 of contracts ($12 premium x 100 shares per contract x 4 contracts). If there was no SMA, they must deposit $4,800.
$2,000 of SMA means the account holder maintains $4,000 of buying power (2x SMA = buying power). This buying power reduces the amount required to be deposited by the investor to $800 ($4,800 initial requirement - $4,000 buying power).
A day trade occurs when an investor buys and sells the same security on the same day*. For example, an investor purchases Nike stock at $125 in the morning and sells it at $130 in the afternoon. While short-term trading is unpredictable and risky, some investors make a living off this type of trading.
*More than two trades may be classified as a single ‘day trade.’ For example, assume an investor purchases 100 ABC shares in the morning. Two hours later, they sell 40 ABC shares. An hour after that, they sell 50 more ABC shares. Right before the close of the market, they sell the last 10 ABC shares. Although a typical day trade only involves two trades (buy shares, then sell same those shares later), this example involving four trades would still be considered one day trade.
When an investor performs four-day trades within a five business day period, they are considered pattern day traders. When this occurs, the investor’s margin account requirements change (most pattern day traders utilize margin accounts). There are two primary changes to know.
First, the minimum equity for these accounts is $25,000 (instead of the typical $2,000 requirement). Second, the investor’s buying power is four times the standard 25% minimum maintenance margin* excess (the amount above the account’s minimum maintenance margin).
*As you might know from your current job, long margin accounts require a minimum maintenance margin of 25% of the portfolio’s current market value.
Broker-dealers that promote day trading strategies must provide a risk disclosure statement to any customer qualifying as a pattern day trader. A substantial risk day traders face is timing risk. “Timing the market,” or consistently making the right trades at the right time, is difficult. If the market moves in a different direction than the investor expects, losses can accumulate quickly.
To ensure retail customers* understand the risks they face when they are determined to be a pattern day trader, the following statements are provided in the risk disclosure statement (and are also available on FINRA’s website):
*Member firms are not required to provide the same disclosures to institutional customers.
Some investors utilize cross guarantees when trading securities. A cross guarantee exists when one account covers another account’s liabilities or margin requirements. While a cross guarantee can exist with typical margin accounts, it is prohibited for day trading accounts.
The margin rules we’ve discussed so far are standard rules that apply broadly to investors. Investors with substantial knowledge and financial resources may qualify for less stringent rules by using portfolio margin.
A portfolio margin account allows customers to trade and hold securities at lower margin requirements based on overall risk.
For example, assume a customer establishes the following positions:
Long 100 ABC shares at $52
Long 1 ABC Jan 50 put at $5
Standard margin rules would require the customer to deposit:
That’s a total of $3,100.
However, in the worst-case scenario, the customer can exercise the put and sell the ABC stock at $50. This results in a maximum loss potential of $700 ($2 stock loss + $5 option premium x 100 shares). A portfolio margin account would require a customer to deposit $700 instead of the $3,100 standard requirement.
These accounts allow investors to take on greater leverage than a typical margin account, so securities regulators want to ensure only “sophisticated” investors utilize them. Customers must maintain a minimum net equity (usually $100,000) to qualify for portfolio margin accounts. Additionally, customers must be approved for naked options writing during the account opening process, which requires additional risk disclosures.
While standard margin rules are relaxed with portfolio margin accounts, minimum deposit and maintenance requirements still apply. If a deficiency exists (e.g., the account falls below minimum maintenance), the customer must satisfy the deficiency within three business days. Satisfying the deficiency may involve liquidating a position or depositing more funds or securities.
FINRA member firms must receive appropriate SRO approval (typically from FINRA) to offer portfolio margin accounts. Additionally, firms must establish a comprehensive written risk methodology (a system for determining the risks an investor faces) based on a specified range of possible market movements and continually monitor these accounts.
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