Minimum maintenance

Minimum maintenance

Margin accounts add risk to investing. If you buy shares in a margin account and those shares lose 100% of their value, you lose the value of the shares and you still have to repay the money you borrowed. That’s leverage: it increases both potential gains and potential losses.

Minimum maintenance rules help keep customer margin accounts from deteriorating too far when the market moves against the investor. They also help protect the broker-dealer from being left with an unpaid loan or an unwanted short position. This section covers minimum maintenance for both long and short margin accounts.

Minimum maintenance for long accounts

You’ll see several numbers and calculations in this section. The exam is more likely to focus on the concept of minimum maintenance than on heavy math, so keep the big picture in mind.

To work with minimum maintenance, it helps to express equity as a percentage of the account’s market value:

$$\text{Equity \%}=\frac{\text{Equity (in \$)}}{\text{LMV or SMV}}$$

Assume an investor buys 200 shares at $30 per share and deposits the required initial margin. The equity formula in dollars is:

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

Now calculate equity as a percentage:

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

That 50% makes sense: the investor’s equity is $3,000 out of a $6,000 long market value, so they own 50% of the position. As the market value changes, the equity (and equity %) changes too. Here’s a full example.

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, set up the account at the time of purchase:

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

• The investor buys $60,000 of stock (200 × $300).
• The investor must deposit 50% of the purchase price (or $2,000, whichever is greater). Here, 50% is greater, so the deposit is $30,000.
• The remaining $30,000 is borrowed from the broker-dealer, which appears as the debit balance.

Next, update the account after the price drops to $175:

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

• LMV falls to $35,000 (200 × $175).
• The debit balance stays at $30,000 because the investor hasn’t borrowed more or repaid any of the loan.
• Equity drops to $5,000.

Now compute the equity percentage:

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

At this point, the investor’s equity has fallen sharply (from $30,000 to $5,000). If the market keeps falling, the broker-dealer faces increasing risk that the $30,000 loan won’t be fully repaid. To reduce this risk, FINRA enforces minimum maintenance rules.

*We discussed how the Federal Reserve sets initial deposit requirements for margin accounts in a previous chapter. FINRA sets minimum maintenance requirements. Be sure to remember which organization sets each requirement!

For long margin accounts, the minimum maintenance requirement is 25% equity. If the equity percentage falls below 25%, the investor or broker-dealer must take steps to bring the account back into compliance. The investor can do this by depositing additional funds, depositing securities from other accounts, or selling securities. You don’t need the detailed mechanics for this exam (those of you taking the Series 7 will need those details).

Minimum maintenance for short accounts

The same basic idea applies to short margin accounts: minimum maintenance helps prevent the account from becoming so undercollateralized that the broker-dealer can’t be repaid. The key difference is the required level. Short accounts must maintain at least 30% equity (not 25% as in long accounts). If equity falls below 30%, the investor or broker-dealer must act to correct it.

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, calculate equity in dollars:

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

Next, calculate equity as a percentage:

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

This account is well below the 30% minimum maintenance requirement. A short account becomes “underwater” if the short market value rises above the credit balance. In that case, the cost to repurchase the shares is greater than the cash and collateral in the account. The investor can correct the deficiency by depositing more funds or closing out some or all of the short position. You don’t need the detailed mechanics for this exam.

This video summarizes the important concepts related to minimum maintenance: