Understanding Margin Accounts

Investing in securities doesn’t always require upfront cash. Margin accounts offer a unique opportunity where you can borrow funds from a broker-dealer to buy securities or even the securities themselves. However, it’s important to note that margin accounts carry additional risks, a lesson many learned in the 1929 crash. They are beneficial when the securities’ values increase, but can be detrimental if the values drop.

Getting the Paperwork Out of the Way

Engaging in margin trading, whether buying or selling short, carries additional risks. Consequently, not only must these accounts receive approval, but traders are also required to receive a Margin Disclosure Statement. This document clearly outlines the inherent risks and specific rules set by the broker-dealer. Key points covered in the Margin Disclosure Statement include:

• The possibility for margin investors to lose more than their initial deposit.
• No entitlement to extra time for addressing a margin call.
• The firm’s right to raise in-house margin and maintenance requirements at any time, without prior notification.
• Authorization for the firm to liquidate securities in the account to cover any unmet margin or maintenance calls, without the need to inform the investor beforehand.
• The investor’s lack of control over which securities are sold from the account to satisfy an unmet margin or maintenance call.

In addition to receiving the margin risk disclosure document, customers are required to sign a margin agreement before they can proceed with purchasing or selling securities on margin. This agreement comprises three primary sections:

1. Credit Agreement: This part outlines the terms under which investors, borrowing money from the broker-dealer to buy securities, will be charged interest. It details the interest rate, the broker-dealer’s calculation method, and the circumstances that could lead to a rate change. This agreement is also known as the interest rate disclosure document.

2. Hypothecation Agreement: Under this agreement, all securities bought on margin must be held in a street name, which means they are registered under the broker-dealer’s name for the customer’s benefit. It also permits the broker-dealer to use some of the customer’s margined securities as collateral for a bank loan, a process known as rehypothecation. Moreover, this agreement authorizes the broker-dealer to sell securities from the account if the equity dips below a specified level.

3. Loan Consent Agreement: This section, also referred to as the loan consent form, grants the broker-dealer permission to lend the customer’s margined securities to other investors or broker-dealers, often for the purpose of short selling.

☝ Not all accounts can be approved for margin trading. For example, custodial accounts, IRAs, 401(k)s, 403(b)s, and so on, cannot trade on margin.

Exploring Long & Short Margin Accounts

Margin accounts facilitate investors in two distinct ways: they can either borrow money to purchase securities, or they can borrow the securities themselves. This leads to two types of transactions in a margin accounts: long and short. In a long transaction in a margin account, an investor buys securities by paying a portion of the securities’ purchase price (usually 50%) and borrowing the remaining amount from the broker-dealer. Investors using this strategy typically anticipate a bull market, aiming to sell the securities later at a higher price for a profit.

Conversely, a transaction in a short margin account involves an investor borrowing securities to sell them immediately in the market. This might seem counterintuitive, as the investor sells securities they don’t own. The goal for these bearish investors is for the price of the security to fall, enabling them to buy back the shares at a lower price and return them to the lender, thus profiting from the price difference.

☝ When a customer buys securities, he can purchase the securities in a cash or margin account, but when a customer sells short securities, the transaction must be executed in a margin account.

Adhering to the Federal Reserve Board’s Regulations

Under the Securities Exchange Act of 1934, the Federal Reserve Board (FRB) is empowered to oversee the extension of credit to clients in the securities industry. This authority includes not just the stipulations of Regulation T, which will be discussed in the subsequent section, but also the determination of which securities are eligible for purchase on margin.

Regulation T

Regulation T, established by the Federal Reserve Board, governs the credit that broker-dealers can offer to clients buying securities. For both long and short margin accounts, Regulation T (commonly referred to as Reg T) mandates that customers must deposit a minimum of 50 percent of the securities’ current market value when purchasing on margin, with the remaining balance being financed through a loan from the broker-dealer.

☝ Regulation T is currently set at 50 percent; however, firms not willing to take as much risk may increase the house margin requirement to 55 percent, 60 percent, 65 percent, and so on.

Regulation T extends beyond margin accounts, encompassing cash accounts as well. In cash accounts, when customers buy securities, they’re given a specific timeframe (one, three, or five business days) to complete payment for the transaction. This period effectively constitutes a credit extension and thus falls under the purview of Regulation T.

Moreover, Reg T specifies which securities are eligible for margin purchasing and which are not.

Securities permissible for margin purchase include:

• Exchange-listed securities.
• Most NASDAQ securities.
• Non-NASDAQ over-the-counter (OTC) securities sanctioned by the Federal Reserve Board.

On the other hand, securities that are not allowed for margin purchase and cannot serve as collateral encompass:

• Most option positions.
• Rights.
• Non-NASDAQ over-the-counter (OTC) securities lacking approval from the Federal Reserve Board.

There are also securities that, while not eligible for margin purchase, can be utilized as collateral after a holding period of 30 days, such as:

• Mutual funds.
• Certain new issues.

☝ New securities cannot be purchased on margin for at least 30 days. Since mutual funds are always new issues, they cannot be purchased on margin. However, after holding them for 30 days or more, they can be placed in a margin account and used as collateral.

Note: It’s important to note that Treasury securities and municipal bonds are not subject to Regulation T, yet they can still be acquired on margin. The margin and maintenance requirements for Treasury securities generally vary from 1 percent to 6 percent of their market value, depending on the maturity period. As for municipal bonds, they too can be bought on margin, with the margin and maintenance requirements being determined by brokerage firms, based on the associated risk.

Margin call

A margin call, also known as a Fed call, federal call, or Reg T call, is a request from the broker-dealer for a customer to deposit funds into their margin account when engaging in a margin transaction, such as purchasing or short selling securities. When a customer undertakes a margin transaction, they are required to meet the Regulation T requirement, typically 50 percent of the total transaction amount, whether it’s a purchase or a short sale. This sum usually needs to be deposited within a period ranging from two to five days, although this can vary depending on the policies of different firms. However, for amounts owing $1,000 or less, the brokerage may opt to simply add this to the customer’s debit balance. In the case of buying securities on margin, customers have the option to deposit fully paid marginable securities instead of cash to fulfill the margin call requirement.

The margin call calculation is straightforward: it’s the total dollar value of the securities bought (or shorted) multiplied by the Regulation T percentage, which is 50 percent. For instance, if an investor buys $50,000 worth of securities on margin, the margin call would amount to $25,000. Here’s how you figure that:

margin call = the current market value of the securities x Reg T
margin call = $50,000 x 50% = $25,000

Setting Up a Margin Account: Initial Requirements

For new margin accounts, the initial margin requirements apply only to the first transaction. Once the account is active, investors can purchase or short securities by simply depositing an amount equal to Regulation T’s requirement, which is based on the current market value of the securities. For the initial transaction in a margin account, customers are required to deposit a specified minimum equity. Presently, Regulation T mandates a deposit of at least 50 percent of the market value of the securities being purchased or shorted. However, both the Financial Industry Regulatory Authority (FINRA) and the New York Stock Exchange (NYSE) have set a baseline deposit of $2,000 or require full payment for the securities.

• Pattern Day Trading: Investors looking to establish a day trading account must meet an initial margin requirement of $25,000 and maintain a minimum equity of the same amount for ongoing trading activities. A pattern day trader account is defined by the action of buying and selling the same security within the same day, or selling short and then buying the same security, executed at least four times within five consecutive business days. (It’s actually a bit more complicated than that, you can check the FINRA interpretation here.)
• Portfolio Margin: This type of margin account caters to investors with a minimum investment of $100,000, although certain broker-dealers may stipulate a higher requirement. Portfolio margin accounts assess the collective risk of the held securities and adjust the margin requirements based on this risk. Investors holding lower-risk securities are subject to reduced margin requirements. This flexibility allows for more leverage, potentially increasing profits when the values of held securities rise, but also amplifying losses when these values fall.

Opening long transactions in a margin account

To initiate a long transaction in a margin account, customers must deposit either the amount specified by Regulation T or $2,000, whichever is higher. However, there’s an exception for purchasing securities under $2,000 on margin. In such cases, the customer is required to pay the full transaction amount. For instance, it wouldn’t be practical for a customer to buy $1,000 worth of securities on margin and deposit $2,000, when they could simply pay $1,000 in a cash account. Nonetheless, even with full payment, the account remains classified as a margin account, enabling the customer to make future margin purchases once their equity exceeds $2,000.

Table 9–1 illustrates the impact of Regulation T and the FINRA/NYSE requirements on the deposit amounts needed to open long margin accounts.

Opening short transactions in a margin account

Remembering the minimum deposit requirement for short transactions is straightforward. The $2,000 minimum set by FINRA and the NYSE is also applicable. Given the higher risk associated with short selling securities, this $2,000 minimum is always in effect, regardless of the transaction size. For example, even if a customer is short selling securities worth just $300, they are obligated to deposit either 50 percent of the securities’ current market value or $2,000, whichever amount is larger. The following outlines the deposit requirements:

Calculating Debit and Equity for Long Positions

LMV - DR = EQ
(Long Market Value) - (debit register) = Equity

In other words, long market value minus debit balance equals equity. The following sections describe the variables of this equation.

Long market value …

The Long Market Value (LMV) represents the current market value of securities bought long in a margin account. This value is not static; it fluctuates in tandem with the market value of the securities. Naturally, an investor holding these securities (being long) would prefer for the LMV to rise. When securities are purchased on margin, the required margin call, or the amount the customer needs to provide, is determined by the LMV of these securities. With Regulation T currently at 50 percent, an investor is required to deposit an amount equating to 50 percent of the securities’ value when purchased on margin.

… Minus debit balance …

The DR, or debit balance, also known as the debit record or debit register, represents the amount a customer owes to a brokerage firm after buying securities on margin. This balance remains constant unless the customer reduces the borrowed amount. This reduction can occur through the sale of securities in the account or by infusing the account with additional funds, such as dividends or direct payments. (It’s worth noting that the debit balance can increase due to interest charges levied by the broker-dealer.) For instance, if an investor buys $20,000 worth of securities on margin, their initial debit balance would be $10,000. This is calculated by first determining the margin call:

margin call = LMV x Reg T
margin call = $20,000 x 50% = $10,000

Then use the margin call and the following formula to determine the debit balance:

DR = LMV - margin call
DR = $20,000 - $10,000 = $10,000

… Equals equity

Equity (EQ) in a margin account represents the investor’s ownership share. Initially, when a margin account is opened, the equity is equivalent to the margin call. However, this equity fluctuates with the rising or falling market value of the securities in the account. If an investor’s equity exceeds the Regulation T requirement, this is termed as excess equity. Conversely, if the equity is below the Regulation T requirement, the account becomes restricted (further details on restricted accounts are provided in a subsequent section).

It’s important to note that when an investor possesses excess equity, they essentially have access to a line of credit, referred to as a Special Memorandum Account (SMA). Importantly, the SMA is integrated within the equity itself, rather than being an additional element. Therefore, when a customer utilizes or withdraws from the SMA, their equity diminishes while their debit balance increases.

Example

Mr. Martin purchases 1,000 shares of ABC common stock at $40 per share using a margin account. After fulfilling the margin call, what amount does Mr. Martin have as his debit balance? The options are:
(A) $16,000,
(B) $20,000,
(C) $24,000,
or (D) $30,000.

The correct answer is Option (B). To determine this, start by formulating the equation:

LMV - DR = EQ

Mr. Martin acquired stock valued at $40,000, equating to 1,000 shares at $40 each. This amount should be recorded under LMV (Long Market Value). The next step is to calculate his payment obligation. By applying Regulation T’s 50 percent rule to the $40,000, it’s evident that Mr. Martin must provide $20,000, which is noted under EQ (the investor’s portion of the account). Given that the LMV is $40,000 and the EQ is $20,000, it logically follows that the DR (debit balance) is also $20,000.

$40,000 - DR = $20,000
DR = $20,000

☝ Brokerage firms aiming to minimize risk might set their house requirements higher than the standard Regulation T requirement. In such scenarios, these house requirements are used in the calculations. For instance, if a brokerage firm’s house requirement is 60 percent, instead of the usual 50 percent under Regulation T, the investor would need to deposit 60 percent of the purchase price. This amount is reflected in the equity (EQ), while the debit balance (DR) would represent the remaining 40 percent of the purchase.

Calculating Credit and Equity for Short Positions

The basic short margin account formula is as follows:

SMV + EQ = CR
(Short Market Value) + (Equity) = Credit Balance

Put simply, the sum of the short market value and the investor’s equity amounts to the credit balance.

☝ A customer buying securities has the flexibility to either pay the full amount upfront (cash account) or opt for a margin purchase (margin account). However, in the case of short selling, where securities are borrowed, the choice is more restricted: These transactions are required to be carried out within a margin account.

Short market value …

The Short Market Value (SMV) refers to the current market value of securities that have been sold short in a margin account. Similar to the LMV in a long account, which fluctuates (as discussed in the earlier ‘Long Market Value’ section), the SMV also varies with changes in the market value of the securities. For investors who are short-selling (selling borrowed securities), a decrease in the SMV is desirable. This allows them to buy back the securities held in the short account at a lower price. When securities are sold short on margin, the required margin call — the amount the customer needs to provide — is determined based on the SMV of the securities. Under Regulation T, set at 50 percent, an investor is required to deposit 50 percent of the value of the short-sold securities.

☝ As with long positions, a brokerage firm may decide to increase the house requirement above the Regulation T requirement.

… Plus equity …

Equity (EQ) represents the investor’s share in a short position. Initially, upon opening such an account, the equity is either $2,000 or 50 percent of the market value of the security as per Regulation T (Reg T), whichever amount is higher.

👉 In a short margin account, the equity increases as the Short Market Value (SMV) of the securities decreases, and conversely, it decreases when the SMV increases.

When an investor’s equity surpasses the Regulation T threshold, this results in excess equity, leading to the creation of a Special Memorandum Account (SMA), which is detailed in a forthcoming section. On the other hand, if an investor’s equity falls below the Reg T requirement, the account becomes restricted.

… Equals the credit balance

For a short position, there is no debit balance (DR), as investors are borrowing securities rather than money. Instead, these accounts feature a credit balance, also known as a credit record, credit register, or CR. Initially, the credit balance comprises the proceeds from selling the stock short (the short market value) and the investor’s deposit into the margin account for the trade (the equity). This balance remains constant unless the investor withdraws excess equity, engages in additional short selling, or covers some of their short positions. For instance, consider an investor who shorts $50,000 worth of securities in an initial margin account transaction with Regulation T (Reg T) set at 50 percent. The first step is to calculate the margin call:

margin call = SMV x Reg T (50%)
margin call = $50,000 x 50% = $25,000

Then you use the margin call and the following formula to determine the credit balance:

CR = SMV + margin call
CR = $50,000 + $25,000 = $75,000

Putting the equation together with an example

In her margin account, Melissa Martin executed a short sale of 1,000 shares of DEF common stock at $30 per share. Before this trade, the account’s short market value (SMV) of securities was $52,000, and the equity stood at $25,000. The task is to determine Melissa’s credit balance following this transaction. The options are (A) $15,000, (B) $45,000, (C) $77,000, or (D) $122,000.

The correct answer is Option (D). This scenario is somewhat complex as it involves a transaction in an already active margin account. Initially, Melissa’s account had an SMV of $52,000 and an equity of $25,000, resulting in a credit balance (CR) of $77,000:

SMV + EQ = CR
$52,000 + $25,000 = CR
CR = $77,000

Knowing the existing credit balance (CR), the task is to ascertain its adjustment due to the recent transaction. Melissa short sold an additional $30,000 in stock (1,000 shares at $30 each), which is added to the SMV (Short Market Value). The next step is to calculate her required contribution. By applying the 50 percent rule of Regulation T to the $30,000, we deduce that Melissa must provide $15,000, recorded under EQ (the investor’s equity). Consequently, with a $30,000 increase in SMV and a $15,000 rise in EQ, the CR (credit balance) experiences an overall increase of $45,000.

SMV + EQ = CR
$30,000 + $15,000 = CR
CR = $45,000

Given that the initial credit balance was $77,000, and it increased by $45,000, the new credit balance after the transaction amounts to $122,000.

👉 It’s important to note that not every margin customer maintains exclusively short or long positions in their margin account. For those facing a scenario where you need to calculate the combined equity of a customer’s long and short margin accounts, there are two approaches. You can either calculate the equations separately for each account and then sum the equities, or you can employ a specific formula designed for this purpose:

LMV + CR - DR - SMV

Handling Excess Equity (SMA)

A Special Memorandum Account (SMA) functions as a line of credit within a customer’s margin account, which can be utilized either to borrow funds or to purchase additional securities on margin. Ideally, if market conditions are favorable, a customer may accumulate more equity in their margin account than required, thereby creating an SMA. When a customer accesses the SMA, it results in borrowing from the margin account, leading to:

• A reduction in equity for both long and short.
• An increase in the debit balance (the amount owed to the brokerage firm) in long.
• A decrease in the credit balance in short.

👉 It’s noteworthy that once an SMA is generated, it remains available until the customer utilizes it, even if the account becomes restricted. For more information on restricted accounts, refer to the section later in this article. An SMA can be likened to established credit, which, much like a credit card, remains accessible until used.

SMAs for long positions

When an investor chooses to purchase securities on margin, they engage in a leveraged position, enabling them to hold a larger amount of securities than they could have afforded by paying in full. In a long position, excess equity arises when the securities’ value in the account appreciates, pushing the equity above the required margin level.

📝 To illustrate this concept, consider the following example:

Mrs. Doeff bought 1,000 shares of GHI Corp. at $50 each on margin. With GHI’s current market price at $70 per share, how much is Mrs. Doeff’s excess equity? The options are (A) $5,000, (B) $7,500, (C) $10,000, and (D) $20,000.
The correct answer is Option (C). This scenario requires setting up a new equation due to the change in market price. First, determine the debit balance. Mrs. Doeff’s purchase amounted to $50,000 (1,000 shares at $50 per share), which is noted under LMV (Long Market Value). Then, Mrs. Doeff was required to deposit the Regulation T amount (50 percent) of the purchase, so $25,000 (50% of $50,000) is recorded under EQ (the investor’s equity). This indicates that she borrowed $25,000 (the DR) from the broker-dealer:

LMV - DR = EQ
$50,000 - DR = $25,000
DR = $25,000

Now comes the twist: The Long Market Value (LMV) adjusts to $70,000, calculated from the new price of $70 per share multiplied by 1,000 shares. Since the Debit Balance (DR), which is the amount borrowed from the broker-dealer, remains unchanged, we carry forward the $25,000 into our updated equation. This leads to the discovery that the Equity (EQ) has risen to $45,000:

LMV - DR = EQ
~~$50,000 - $25,000 = $25,000~~
$70,000 - $25,000 = $45,000

Next, calculate the margin requirement by multiplying the Long Market Value (LMV) by Regulation T’s 50 percent rule. This determines the amount Mrs. Doeff should maintain in Equity (EQ) to meet the 50 percent requirement. By calculating $35,000 (50% of $70,000), and comparing it to her EQ, it’s evident that Mrs. Doeff, with $45,000 in equity, possesses $10,000 in excess equity, indicating she has $10,000 more than the required amount:

LMV - DR = EQ
~~$50,000 - $25,000 = $25,000~~ 
$70,000 - $25,000 = $45,000
(50% x $70,000) = $35,000
-> $10,000 excess equity

☝ The ‘R’ in DR (Debit Record) serves as a reminder that the debit balance stays constant even as market prices fluctuate. It’s important to remember that an increase in SMA equates to an increase in buying power. This relationship is more clearly illustrated in the table below for easier understanding.

If an investor intends to use or withdraw her SMA, it can only be used to the extent that it won’t drop the account below minimum maintenance.

Loan value

Loan value acts as the counterpart to Regulation T. For instance, if Regulation T is set at 50 percent, then the loan value is also 50 percent (calculated as 100% minus 50% Regulation T). Essentially, this figure signifies the maximum amount a brokerage firm is willing to lend a customer against securities purchased in a margin account. As the securities’ value increases (or decreases, in the case of a short position), the loan value correspondingly changes. For example, if a customer initially buys securities worth $20,000 on margin, the loan value would be $10,000 (50 percent of $20,000). Should the securities’ value rise to $26,000, the loan value would then increase to $13,000 (50 percent of $26,000).

It’s important to recall, as mentioned earlier, that fully paid marginable securities can be used to satisfy a margin call. Therefore, for a margin call of $5,000, one would need to deposit marginable securities with a loan value of $5,000. With Regulation T at 50 percent, the customer must deposit securities valued at $10,000 to fulfill the margin call. Since Regulation T is 50 percent, half of these securities, or $5,000, would be utilized to meet the margin call.

SMAs for short positions in a margin account

In contrast to a long position, an investor with a short position in a margin account gains excess equity when the price of the securities within the account falls. An SMA, or Special Memorandum Account, acts as a line of credit, which investors can use either to withdraw cash or to facilitate additional purchases or short sales of securities on margin.

👉 Excess equity refers to the portion of equity in a margin account that exceeds the requirement set by Regulation T.

📝 Now, let’s test your understanding of calculating excess equity in a short positon in a margin account:

Mrs. Smith engaged in a short sale of 1,000 shares of JKL Corp. at $60 per share on margin. If JKL’s current market price is $50 per share, what is Mrs. Smith’s excess equity?

The options are (A) $5,000, (B) $7,500, (C) $10,000, and (D) $15,000.
The correct answer is Option (D). This problem requires a new equation due to the change in market price. Begin by determining the credit balance. Mrs. Smith’s short sale amounted to $60,000 (1,000 shares at $60 each), entered as the SMV (Short Market Value). She also needed to deposit 50 percent of this value as per Regulation T, so $30,000 (50% of $60,000) is recorded under EQ (the investor’s equity). This makes the credit balance (CR) $90,000:

SMV + EQ = CR
$60,000 + $30,000 = CR
CR = $90,000

Now, with the Short Market Value (SMV) adjusting to $50,000 (based on $50 per share multiplied by 1,000 shares), it’s essential to recalculate the investor’s current equity and document this under the SMV. In the context of a short position, as the market price fluctuates, the Credit Balance (CR) remains constant. Therefore, you should carry over the previous CR of $90,000 directly into the new calculation. Consequently, this results in an increased Equity (EQ) amounting to $40,000, which is the difference between the SMV of $50,000 and the CR of $90,000:

SMV + EQ = CR
~~$60,000 + $30,000 = $90,000~~
$50,000 + $40,000 = $90,000

Next, apply Regulation T to the Short Market Value (SMV) to ascertain the required equity amount for Mrs. Smith to meet the 50 percent threshold. This involves calculating the margin requirement, which is $25,000 (50% of $50,000), and then comparing it to her current equity. Given that Mrs. Smith’s equity stands at $40,000, it reveals that she possesses excess equity of $15,000, indicating she has $15,000 more than the necessary amount:

SMV + EQ = CR
~~$60,000 + $30,000 = $90,000~~ 
$50,000 + $40,000 = $90,000
(50% x $50,000) = $25,000
-> $15,000 excess equity

☝ The R in CR should help you remember that the credit balance remains the same as the market price changes.

Using buying/shorting power

Buying power in long positions and shorting power in short positions refer to the total dollar value of securities that a customer can acquire on margin utilizing their excess equity, also known as SMA (Special Memorandum Account). The calculation for both is derived by dividing the SMA by the Regulation T (Reg T) requirement:

buying or shorting power = SMA / Reg T

Example

Mr. Smith has a margin account with a long market value of $20,000, a debit balance of $5,000, an equity of $15,000, and an SMA of $3,000. If Regulation T is set at 60 percent, what is the buying power?
(A) $3,000
(B) $5,000
(C) $6,000
(D) No buying power

The correct answer is Option (B). Fortunately, this question provides the SMA (Special Memorandum Account), so there’s no need for you to calculate it independently. The buying power in a margin account indicates the amount in securities an investor can purchase (or short sell) without the need for additional funds. To determine this, simply divide the SMA by the Regulation T requirement:

buying power = SMA / Reg T = $3,000 / 60% = $5,000

Buying power for pattern day trading accounts

Pattern day trading accounts maintain a minimum maintenance requirement of 25 percent, similar to that of regular customers. However, the calculation of buying power differs. For pattern day traders, buying power is quadrupled, based on the excess of the maintenance margin (the equity above the 25 percent minimum requirement). In contrast, for regular margin accounts, the buying power is twice the amount of the Special Memorandum Account (SMA). It’s important to note that pattern day traders are not allowed to use cross guarantees and must independently fulfill the margin or maintenance requirements of their account. This means that funds from another investor’s account, or even another account owned by the pattern day trader, even under a written agreement, cannot be utilized to meet margin requirements.

Navigating Limitations When Market Trends Are Unfavorable

Securities often move in directions contrary to investors’ expectations. In a margin account, such deviations can lead to accelerated financial losses. When the equity in a margin account falls below the Regulation T (or house) requirement, the account enters a restricted status. The situation becomes more critical if the long equity drops below 25 percent, or 30 percent in the case of a short position. The following sections provide detailed information on restricted accounts and the requirements for minimum maintenance.

Understanding Restricted Accounts

In the earlier sections, we discussed scenarios with favorable market conditions. But what if the market price of securities held long falls instead of rising? Or if the securities held short perform exceptionally well? Such situations can lead to the account becoming restricted. A restricted account occurs when the equity is less than the required margin. However, being restricted doesn’t prohibit investors from buying (or short selling) securities in the margin account. They can still engage in these activities, provided they meet the margin requirement for the new transactions.

Restricted margin accounts (long positions)

A restricted account is calculated the same way as the excess equity (as discussed in the earlier section Let the Good Times Roll: Handling Excess Equity), but the investor has less than 50 percent of the long market value (LMV) in equity instead of more than 50 percent.

Restricted accounts share the same calculation method as excess equity. The key distinction lies in the investor’s equity percentage, which is less than 50% of the long market value (LMV) in a restricted account compared to over 50% in an excess equity scenario.

Example

Macy purchased 500 shares of MNO common stock on margin when MNO was trading at $30 per share. If MNO is currently trading at $25 per share, by how much is Macy’s margin account restricted?
(A) $1,250
(B) $2,500
(C) $5,000
(D) $6,250

The correct answer is Choice (A). You may notice the similarities between figuring out excess equity and determining whether an account is restricted. If an account is restricted, the account contains less equity than needed to be at 50 percent of the LMV. First, figure out Macy’s debit balance. Macy purchased $15,000 worth of securities (500 shares × $30 per share), so enter $15,000 under the LMV (long market value). Then Macy had to deposit the Reg T amount (50 percent) of the purchase, so enter $7,500 (50% × $15,000) under the EQ (the investor’s portion of the account). She borrowed $7,500 (the DR) from the broker-dealer:

LMV - DR = EQ
$15,000 - DR = $7,500
DR = $7,500

Next, find the investor’s current equity. The LMV changes to $12,500 ($25 × 500 shares), so enter that under the LMV. Because the DR (the amount borrowed from the broker-dealer) doesn’t change, bring the $7,500 straight down from the preceding equation. You find that the EQ has decreased to $5,000 ($12,500 — $7,500):

LMV - DR = EQ
~~$15,000 - $7,500 = $7,500~~ 
$12,500 - $7,500 = $5,000

Now multiply the LMV by Reg T to get the margin requirement, the amount Macy should have in equity to be at 50 percent. Take the $6,250 ($12,500 × 50%) and compare it to the current equity. Because Macy has only $5,000 in equity, her account is restricted by $1,250:

LMV - DR = EQ
~~$15,000 - $7,500 = $7,500~~
$12,500 - $7,500 = $5,000
(50% x $12,500) = $6,250
-> ($1,250) restricted

☝ Calculating excess equity, also known as Special Memorandum Account (SMA), and determining if an account is restricted follow a similar process. When the equity in an investor’s account exceeds the required amount, it results in SMA. Conversely, if the equity is less than the required level, the account is considered restricted. Essentially, the status of the account — whether it has SMA or is restricted — depends on how the investor’s equity compares to the mandatory equity requirement.

Restricted margin accounts (short positions)

In a short margin account, if the market price of the securities rises instead of falling, it negatively impacts the account. This increase in market price can lead to the account becoming restricted. The process to determine whether the account is restricted is akin to calculating excess equity, but with a key difference: for a restricted account, the investor’s equity is less than 50 percent of the Short Market Value (SMV), as opposed to having more than 50 percent in the case of excess equity. This situation reflects a decline in the margin account’s health due to the unfavorable market movement of the held securities.

Example

Mr. Bruce sold short 400 shares of PQR common stock on margin at $40 per share. If PQR is currently trading at $44 per share, how much is the account restricted?
(A) $2,400
(B) $6,400
(C) $8,800
(D) $16,000

The answer you want is Choice (A). First, figure out the credit balance. Mr. Bruce sold short $16,000 worth of securities (400 shares × $40 per share), so enter $16,000 under the SMV (short market value). Then Mr. Bruce had to deposit the Reg T amount (50 percent) of the purchase, so enter $8,000 (50% × $16,000) under the EQ (the investor’s portion of the account). You find that the credit balance (CR) is $24,000:

SMV + EQ = CR
$16,000 + $8,000 = CR
CR = $24,000

Next, find Mr. Bruce’s current equity. The SMV changes to $17,600 ($44 × 400 shares), so you need to put that under the SMV in a new equation. In a short account, the CR remains the same as the market price changes, so you need to bring the $24,000 straight down from the preceding equation. You can see that the EQ has decreased to $6,400 (the difference between $17,600 and $24,000):

SMV + EQ = CR
~~$16,000 + $8,000 = $24,000~~
$17,6000 + $6,4000 = $24,000

Now multiply the SMV by Regulation T to get the amount Mr. Bruce should have in equity to be at 50 percent. Take the $8,800 ($17,600 × 50%) and compare it to the EQ. Because Mr. Bruce has only $6,400 in equity ($2,400 less than the Reg T requirement), his account is restricted by $2,400:

SMV + EQ = CR
~~$16,000 + $8,000 = $24,000~~
$17,600 + $6,400 = $24,000
(50% x 17,600) = $8,800
-> ($2,400) restricted

Maintaining minimum requirements in a margin account

While it’s permissible to have a restricted margin account, falling below the minimum maintenance requirement is a more critical issue. In such cases, customers face a maintenance call (also known as a maintenance margin call or Fed call). This demands investors to urgently deposit funds into their margin account to meet the shortfall. In stockbroker terms, this means acting “promptly” to restore the account to the required maintenance level. This scenario underscores the importance of monitoring margin accounts to ensure they meet regulatory and brokerage firm maintenance requirements.

Minimum maintenance (long positions)

Minimum maintenance is 25 percent of the long market value. The calculations are the same as for restricted accounts (see the preceding sections) until you get to the last step.

Example

Mark purchased 1,000 shares of STU common stock on margin when STU was trading at $55 per share. If STU is currently trading at $35 per share, what is the maintenance call?
(A) $1,250
(B) $7,500
(C)$8,750
(D) $10,000

The correct answer is Option (A). This scenario, similar to the previous examples with a slight variation in the final step, illustrates a situation where an account remains restricted but doesn’t breach the minimum maintenance threshold. If an account does fall below this level, immediate action is required. The customer must either infuse additional funds, deposit fully paid securities, or liquidate enough margined securities to elevate the account above the minimum maintenance level. To start, calculate the debit balance using the market value at the time of purchase. For instance, Mark’s purchase of securities amounted to $55,000 (1,000 shares at $55 each), which sets the Long Market Value (LMV). He then deposited the Regulation T required amount, 50% of the purchase value, which is $27,500, under the Equity (EQ) section of the account. Consequently, it’s determined that he borrowed $27,500 (the Debit Record, DR) from his broker-dealer.

LMV - DR = EQ
$55,000 - DR = $27,500
DR = $27,500

Then find Mark’s current equity. The LMV changed to $35,000 ($35 × 1,000 shares), so you need to put that value under the LMV. Because the DR (the amount borrowed from the broker-dealer) doesn’t change, you bring the $27,500 straight down. Therefore, the EQ has decreased to $7,500:

LMV - DR = EQ
~~$55,000 - $27,500 = $27,500~~
$35,000 - $27,500 = $7,500

Now multiply the LMV by the 25 percent minimum maintenance requirement to get the amount Mark should have in equity to be at minimum maintenance. Take the $8,750 ($35,000 × 25%) and compare it to the current equity. Because Mark has only $7,500 in equity, he’ll receive a maintenance call of $1,250:

LMV - DR = EQ
~~$55,000 - $27,500 = $27,500~~
$35,000 - $27,500 = $7,500
(25% x $35,000) = $8,750
-> ($1,250) maintenance call

Minimum maintenance (short positions)

Similar to long positions, short positions can also lead the margin account to operate in a restricted state. If the account drops below the minimum maintenance level, the customer faces a maintenance call. The minimum maintenance requirement is set at 30 percent of the current market value of the securities. The initial steps to calculate this are akin to those used for determining the Special Memorandum Account (SMA) or the restriction level of an account, as detailed in the section on restricted accounts earlier in this article. The key difference arises in the final step of the calculation, which addresses the specific maintenance requirements.

☝ Minimum maintenance for a long account is 25 percent of the current market value, and minimum maintenance on a short account is 30 percent of the current market value.

Example

Mrs. Martinez sold short 1,000 shares of VWX common stock on margin at $50 per share. If VWX is currently trading at $60 per share, what is the maintenance call?
(A) $0
(B) $2,000
(C) $3,000
(D) $8,000

The correct answer is Choice (C). First, find Mrs. Martinez’s credit balance. Mrs. Martinez sold short $50,000 worth of securities (1,000 shares × $50 per share), so enter $50,000 under the SMV (short market value). Then Mrs. Martinez had to deposit the Reg T amount (50 percent) of the purchase, so enter $25,000 (50% × $50,000) under the EQ (the investor’s portion of the account). The credit balance (CR) is $75,000:

SMV + EQ = CR
$50,000 + $25,000 = CR
CR = $75,000

Next, find Mrs. Martinez’s current equity. The SMV changed to $60,000 ($60 × 1,000 shares), so you need to put that value under the SMV. In a short account, the CR remains the same as

SMV + EQ = CR
~~$50,000 + $25,000 = $75,000~~
$60,000 + $15,000 = $75,000

Now multiply the SMV by 30 percent to get the amount Mrs. Martinez should have in equity to be at minimum maintenance. Take the $18,000 ($60,000 × 30%) and compare it to the equity. Because Mrs. Martinez has only $15,000 in equity, she’ll receive a maintenance call of $3,000:

SMV + EQ = CR
~~$50,000 + $25,000 = $75,000~~
$60,000 + $15,000 = $75,000
(30% x $60,000) = $18,000
-> ($3,000) maintenance call

Conclusion

Understanding the dynamics of margin accounts, especially when the market turns unfavorable, is crucial for you as an investor. Knowing how to calculate restrictions and maintenance calls is a key skill that can help you manage risks effectively in margin trading. This knowledge equips you to navigate the complexities of the financial markets and make informed decisions to protect and optimize your investments.

Source: https://www.finra.org/rules-guidance/rulebooks/finra-rules/4210