Other margin rules

Beyond opening margin requirements and understanding minimum deposit requirements, the following margin-related concepts must be known for the exam:

• Minimum maintenance
• Specialized memorandum account (SMA)
• Pattern day trading
• Portfolio margin

Minimum maintenance

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, they lose the overall value of those shares plus the 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.

Minimum maintenance is generally only a concern with short (naked) options. When this type of position is established, a customer must maintain an equity equal to the greater of the initial deposit requirements (covered in the last chapter) or 10% of the total exercise value plus the current premium. Most of the time, the initial deposit requirements are the greater of the two. If so, 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.

Specialized memorandum account

When margin accounts gain value, they also gain additional buying power (for long accounts) or selling power (for short accounts). In plain terms, the investor may be able to execute transactions without making additional cash deposits. When a margin account gains value, it also gains something called special memorandum account (SMA).

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 can be traded without additional deposits.

An account’s buying or selling power equals twice the amount of the account’s SMA. Let’s explore this with 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?

Pattern day trading

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. If this occurs, the investor’s margin account requirements change (most pattern day traders utilize margin accounts). While you’ll learn more about them later in this chapter, there are two primary changes to be aware of.

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 simply making the right trades at the right time, is incredibly difficult to do consistently. To be successful as a day trader, a person must place most of their trades at the “right” times. However, predicting market movements, especially in the short term, is challenging (to say the least). If the market were to move in another direction than an investor expects, they could lose significant value 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):

• Day trading can be extremely risky
• Be cautious of claims of large profits from day trading
• Day trading requires knowledge of securities markets
• Day trading requires knowledge of a firm’s operations
• Day trading will generate substantial commissions, even if the per trade cost is low
• Day trading on margin or short selling may result in losses beyond your initial investment

*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.

Portfolio margin

The margin rules we’ve discussed are standard rules applicable to all types of 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, let’s 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 50% of the stock position ($2,600) and 100% of the put premium ($500) for 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., account falls below minimum maintenance), the customer must “fix” (satisfy) the deficiency within three business days. Fixing 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.