Margin Accounts: Long Positions

The equation and the documents

Long market value minus the debit balance equals equity.

LMV is what the securities are worth today. The debit balance — the debit register — is what the customer owes the firm, and it does not change when the market moves; it changes only when the customer buys more, sells, deposits, withdraws or accrues interest. Equity is the residual and it absorbs every market movement.

Buy $20,000 of stock in a margin account with a 50 percent requirement: the customer deposits $10,000 and borrows $10,000. LMV $20,000, DR $10,000, equity $10,000. If the stock rises to $30,000, the debit is still $10,000 and equity is $20,000. If it falls to $14,000, the debit is still $10,000 and equity is $4,000. The debit is a constant; that is the single most useful fact in this lesson.

Three documents. The credit agreement discloses the terms of the loan — the interest rate, how it is computed, and when it is charged — and the customer must sign it. The hypothecation agreement pledges the customer's securities as collateral and permits the firm to repledge them to obtain a bank loan; the customer must sign this too. The loan consent agreement permits the firm to lend the customer's margined securities to others, typically to facilitate short sales; it is optional and the customer may decline it.

FINRA Rule 2264 requires that a margin disclosure statement be provided at or before opening the account and annually thereafter. It states in plain terms the things customers most often do not know: that they can lose more than they deposited, that the firm can force a sale without contacting them, that they are not entitled to choose which securities are sold, and that the firm can raise its maintenance requirements without advance notice.

Regulation T and the payment period

The Federal Reserve Board's Regulation T sets initial margin. Under the current supplement, the requirement for a margin equity security is 50 percent of the current market value, or the percentage set by the regulatory authority where the trade occurs, whichever is greater.

For exempted securities, non-equity securities, money market mutual funds and exempted securities mutual funds, Regulation T defers to the good faith requirement of the creditor and to the exchange's requirement — which is why government and municipal bonds carry much lower margin than stock.

Options may not be purchased on margin at all; long options must be paid for in full, with a limited exception for listed options with more than nine months to expiration. New issues are not marginable for thirty days after the offering, and neither are mutual fund shares.

The payment period is defined in Regulation T as the number of business days in the standard settlement cycle plus two business days. With settlement at T+1, that is three business days after the trade date. If payment is not made, the firm must either obtain an extension from its designated examining authority or liquidate the position, and the account is then frozen for 90 days — during which the customer may still trade but must pay in advance.

FINRA Rule 4210 layers its own requirement on top: the initial equity in a margin account must be the greater of the Regulation T requirement, the maintenance requirement, or $2,000 — except that cash need not be deposited in excess of the cost of the securities purchased. So a customer buying $1,500 of stock deposits $1,500, not $2,000; a customer buying $3,000 of stock deposits $2,000, not $1,500.

Excess equity and SMA

When the market moves in the customer's favour, equity exceeds the Regulation T requirement of 50 percent of current market value. The difference is excess equity.

From the earlier example: LMV rises to $30,000 with a $10,000 debit, so equity is $20,000. The Regulation T requirement on $30,000 is $15,000. Excess equity is $5,000.

The special memorandum account is the line of credit that excess equity creates. SMA is not cash and it is not part of the account's value; it is a notation of borrowing power the customer has earned. Two properties define it.

SMA increases when excess equity is created — by appreciation, by a cash deposit, by a sale, or by cash dividends and interest received.

SMA does not decrease when the market falls. Once credited, it stays until the customer uses it. This is deliberately generous and it is the property the exam tests: a customer whose stock appreciated and then fell back retains the SMA created on the way up.

On a sale of securities in a margined long account, half the proceeds go to SMA and the rest reduces the debit — the 50 percent retention requirement.

Buying power is SMA times two, because a dollar of SMA supports two dollars of purchase at a 50 percent requirement. A customer with $5,000 of SMA has $10,000 of buying power. Withdrawing SMA in cash, by contrast, takes it dollar for dollar and increases the debit balance by the same amount.

SMA may only be used if the account remains above its maintenance requirement afterwards. A customer whose account is at the maintenance line cannot draw SMA to buy more securities.

Restricted accounts

A long margin account is restricted when its equity is below the Regulation T requirement of 50 percent of current market value — but still above the maintenance requirement.

Restriction is not a call. It has one practical consequence: the 50 percent retention requirement on sales. When a customer in a restricted account sells securities, only half the proceeds may be withdrawn or credited to SMA; the other half must go to reducing the debit balance.

Worked example. LMV $20,000, DR $12,000, equity $8,000. The Regulation T requirement on $20,000 is $10,000, so the account is restricted by $2,000. Equity is 40 percent of market value — above the 25 percent maintenance requirement, so no call. The customer sells $4,000 of stock: $2,000 reduces the debit to $10,000, and $2,000 is credited to SMA.

A customer may always deposit cash or fully paid marginable securities to remove the restriction, and note that a deposit of securities counts at their loan value — 50 percent of market value under Regulation T — so removing a $2,000 restriction takes $4,000 of securities or $2,000 of cash.

What happens when equity falls below the maintenance requirement is the next lesson's subject, along with the short side of the account.