Trading in a Margin Account can be very risky if you don’t know exactly what you are doing! The gains can be significantly larger when trading on margin, but so can the losses. Therefore, this week in the Knowledge Corner we will cover some important basics on the topic.
1. Simply stated, a Margin Account is an account that permits the account holder to trade securities on borrowed money. The brokerage firm at which you hold your brokerage account, extends credit to you for use in the purchasing of securities. It’s called a Margin Account because you borrow money relative to a specified margin of the equity balance in your account.
2. The Equity balance is the current Market value of the securities in your account minus the Debit balance (the money you have borrowed). If there is short selling activity in the account the Equity includes any Credit balance (the cash you have deposited) minus the short market value. More about Short Selling in a separate blog post.
3. At the time of opening a margin account, you as the account holder are required to sign a Margin Agreement presented by the Brokerage you are using. The agreement specifies the rules for borrowing on margin against your brokerage account.
4. The Initial Margin Requirement is a part of the Regulation T that is established by the Federal Reserve. It specifies the minimum initial margin requirement of 50%. Which means you need to have at least 50% equity to open a new securities position. Reg T also specifies a minimum maintenance margin of 25% but many brokerage houses set their own higher maintenance margin. Additionally, Reg T requires a minimum deposit of $2,000 to open a new margin account, regardless of your initial purchase of securities.
5. The broker institution set their own Maintenance Margin Requirement. It is the minimum percentage level of equity you need to maintain in your margin account. It can be the same as the 25% minimum maintenance margin established in the Reg T or larger. It’s sometimes referred to as the “house margin”.
6. If and when the equity level in your account falls below the maintenance margin requirement your broker will issue a Margin Call. This is a notice to take action to satisfy the maintenance margin requirement by depositing more cash in to the account or liquidate securities sufficient enough to reduce the margin loan and bring the equity level up again.
7. The Debit Balance is the loan amount you have borrowed from the broker. Just like any loan, the broker charges you interest on the debit balance.
8. The process called Hypothecation is the loan agreement between the customer and the brokerage. It states that the customer pledge the securities in an account to the brokerage so that the broker is legally permitted to sell the securities in the event that the customer fails to satisfy a margin call.
9. Typically, the securities in these accounts are required to be held in Street Name. This means that the securities are held in the broker’s custody and in the broker’s name as supposed to the owner’s name. This makes the process of transferring securities much easier and allows for the securities in the account to be liquidated by the broker if necessary.
10. If your trading strategies go well, your margin account will contain some Margin Excess Equity. This is the difference between the actual equity in your account and the equity that’s necessary to satisfy the maintenance margin requirement. Say your initial margin requirement is 50% and your broker’s maintenance margin requirement is 40%. You decide to deposit $3,000 cash and then purchase securities worth $6,000. Now, let’s say your investments are successful and your Total Account Value increases to $7,800. Your debit balance is still only $3,000 and your total equity is now $4,800. Although the initial margin requirement is 50%, the maintenance margin requirement is only 40% or $3120 ($7,800*40%). Therefore, your Margin Excess Equity is $1,680.
11. Excess equity is sometimes (but not always) used for calculating Margin Buying Power where the MBP is calculated as 2 times current excess equity plus any cash available. Technically, the Excess Equity in that case is used as the Initial Margin Requirement for buying more securities.
Are you ready to try out a margin account on SprinkleBit? Sign up for a Brokerage Account today!