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August 19, 2022

Cash versus Margin Accounts

When you are ready to trade stocks, you must open a brokerage account. This process is relatively simple and many firms accept online applications (although most require that you mail or fax an actual signature). One of the questions you will be asked on the application is whether you wish to open a cash or margin account. There are advantages and disadvantages to each and it's important to understand what those differences are before you sign the agreement.

Settlement Periods

Before you can understand the differences between cash and margin accounts, it helps to understand a concept called the settlement period. When you buy or sell a stock, there is currently a three business day settlement period. This means that the cash must be settled in the account within three full business days (not counting the trade date). As a shorthand notation, you will probably hear your broker refer to this settlement period as T+3, which stands for "trade date plus three business days."

For example, if you buy $5,000 worth of stock on Monday, you must have a check to your broker by close of business on Thursday since that is the third business day not counting the Monday purchase date. If one or more of those days happens to be a holiday then you do not count those days either; you only count three full business days from the trade date. Similarly, if you sell a stock, you must deliver the stock certificates within the three business day period as well. Of course, if you already have the cash or stock in your account then there is nothing you need to do. The broker will just take the stock or cash out of the account on the settlement day for you. The settlement period is just a grace period that allows investors to get the cash or securities together that are not already in the account.

Cash Account

If you elect to open a "cash" account, then all purchases must be paid 100% in full. If you buy $5,000 of stock on Monday, then a full $5,000 check (plus commissions) must be deposited to your broker three business days later on Thursday. Cash accounts, as the name implies, are accounts where all assets are fully paid in cash. But don't let the name mislead you - you cannot actually deposit cash with your broker. Most brokers will only accept personal checks, cashiers checks, wire transfers, or any form of payment that leaves a traceable paper trail. The name "cash account" is really implying that all securities are paid for in full.

You can purchase many types of assets in a cash account including stocks, bonds, and mutual funds; however, you cannot purchase options or futures contracts. (For those you'll need a margin account, which we'll cover shortly.)

One of the obvious drawbacks to the cash account is that you must have substantial cash deposited with your broker or at other institutions where it is readily accessible if you wish to buy and sell securities. If you buy just 100 shares of a $30 stock, you've got over $3,000 invested including commissions. (You can see that if you wish to buy several stocks and mutual funds, the numbers add up quickly.) But this drawback is also an advantage. By paying for all securities in full, the worst that can happen is that you lose exactly what you have into the trade. While this sounds potentially devastating, it can get worse with a margin account as you could lose more money than what you have invested.

Margin Account

In 1934, the Securities and Exchange Commission (SEC) provided for the extension of credit by brokerage firms under "Regulation T." By providing credit, the SEC hoped to provide a more liquid market where investors could invest additional funds by borrowing money, which should dampen the downfalls in the market. This was one of the many changes made in 1934 as a way to reduce the likelihood of another Crash of '29! In other words, if the market were to fall precipitously during a panic sell off, investors could borrow against their securities to buy some of the "potential bargains" without having the funds readily available. Under this act, brokerage firms can extend credit to customers while using the securities in the account as collateral.

In order to open a margin account, you simply need to sign the "margin agreement" forms provided by your broker when you open the account. Even if you do not sign the agreement when you open the account, you can always sign the margin agreement at a later time to provide margin ability to your account.

Not all account types can use margin trading. For instance, Individual Retirement Accounts (IRAs) and Uniform Gifts (or Transfers) to minors accounts UGMA/UTMA cannot use margin. Most fiduciary accounts are also barred, unless there is specific authorization to use margin. Under certain circumstances though, you may be able to use margin in a 401(k) account.

If you open a margin account, you are allowed to buy securities by only paying for a portion of them and then borrow the rest. Having a margin account does not mean that you must borrow money; you are always free to pay for 100% of the trade. But by signing the margin account agreement, the brokerage firm is just providing you with the ability to borrow funds if you choose. Margin accounts can be fairly tricky and this is not meant to be a full course on margin trading. However, it will provide you with more than the basics of how they work.

The Initial Trade

If you have a margin account, you are only required to pay for 50% of the trade, which is the percentage established under Regulation T and is therefore called the "Reg T" amount. So if you buy $5,000 worth of stock, you are only required to deposit $2,500 with your broker within three business days. Your broker automatically loans you the remaining $2,500 and holds the $5,000 worth of securities as collateral for the loan. You are allowed to sell the stock at any time and the amount that's left over after paying the $2,500 loan is yours to keep.

If you borrow funds to buy securities, you are trading on margin. The amount you borrow is your margin balance.

Are all Stocks Marginable?

In order to buy on margin, the security must be marginable by the SEC and your broker.

As a general rule, all listed stocks (those on the NYSE) will be marginable as will most on the Nasdaq National Market. Also as a general rule, no stocks under $5, penny stocks, OTCBB (Over-the-counter bulletin board stocks), or IPOs (Initial Public Offerings) can be purchased on margin. (IPOs, however, can usually be purchased on margin after a certain grace period.) Just because the SEC says a particular stock is marginable does not mean your broker must allow it; brokers are always allowed to make the rules stricter. However, your broker can never relax the rules; they cannot allow a stock to be marginable if the SEC says that it is not eligible.

$2,000 Minimum

In order to borrow funds, the minimum amount you can invest is $2,000. If, for example, you buy $3,000 worth of stock in a margin account, the broker will require a $2,000 minimum deposit even though 50% is only $1,500. If you purchase $2,000 or less in stock, then the full amount must be deposited. For instance, if you buy $1,800 worth of stock, then you must deposit the full $1,800 and not $900. In other words, you must either deposit $2,000 or 50%, whichever is greater.

Market Values and Equity

When you buy stock on margin, you are leveraging your money. This simply means that you are getting a bigger percentage return on your money if the stock rises. However, leverage works in the other direction too. If the stock falls, you will lose at twice the rate as compared to stock that is held in a cash account. To understand the basics of margin accounts, you must understand the relationships between market values, loan amounts, and equity. Let's start with a simple example that most of you are familiar with; that is, the mortgage on your home.

If you buy a $200,000 home and place $50,000 down, then you are borrowing the balance, or $150,000. The accounting looks like this:

Market Value = $200,000

- Loan Balance = $150,000

Equity = $50,000

The market value minus the loan balance is called your equity. Equity is what you'd have left after selling the house and paying off the loan. Equity can be thought of as "what you own minus what you owe."

Notice that your equity can fluctuate as your home value fluctuates. In most cases, home prices just seem to keep rising but there's nothing that says that must happen. The reason the equity fluctuates is because the loan value stays relatively constant (it actually progressively declines each month based on your monthly payments. The point we're trying to make is that the loan balance is not affected by changes in your home's value). If the home price suddenly increased by $50,000 to $250,000, then your equity increases by $50,000 as well:

Market Value = $250,000

- Loan Balance = $150,000

Equity = $100,000

Any change in the market value of the house is directly reflected - whether up or down - in the equity.

Also notice that, if you were to sell your house, then the percent return on your money is much greater since you borrowed money. Using the above example, assume your home value rises 25% to $250,000. If you sell the house for $250,000, then you are left with $100,000 cash, or equity, after paying off the loan. The $100,000 that you're holding represents a profit of $50,000, or a 100% increase on your investment. But now let's assume that you had purchased the home outright for $200,000. After selling it for $250,000, the $50,000 profit only represents a 25% profit. By putting a down payment that is only a fraction of the value of the house, your profit was magnified by a factor of four (100% vs. 25%). The reason is simple: You only deposited $50,000, or one-fourth (0.25) the value of the home, which means that all changes in the home's value will be magnified by the reciprocal amount (1/0.25), which is four times. This magnification is called "leverage," which means you are magnifying, or leveraging, the return on your money. In other words, because you are controlling the full value of the house for only $50,000, then all future increases (or decreases) in the home's value will be magnified when compared with someone who places more money down.

But you must remember that leverage works in both directions. If the home value were to fall 10% to $180,000, your loss would be four times as well, or a 40% loss. We can show this with our basic formula:

Market Value = $180,000

- Loan Balance = $150,000

Equity = $30,000

If you put $50,000 into the house and receive $30,000 from the sale, then that represents a 40% loss on your original investment. Don't ever forget that leverage works in both directions.

Mechanics of Margin Accounts

We can use a similar formula for determining what your account will look like if you're on margin. Let's assume you have a margin account and buy $10,000 worth of stock. Remember, the margin account just means you have the ability to borrow money for the trade; you are not required to at any time. However, if you do wish to borrow money, you must send in a minimum of 50%, or $5,000. Again, this 50% requirement is called the "Reg T" amount; it is also called the "Fed Call." You now have three business days (not counting the trade date) to get the $5,000 check to your broker.

The day you place the trade, your account would show that you have $10,000 worth of stock and a Fed Call of $5,000. Again, the Fed Call is telling you the minimum amount you must send to your broker within three business days (you are certainly allowed to send more). Once your broker receives the check, your account would look like this:

Market Value = $10,000

- Debit Balance = $5,000

Equity = $5,000

As with the house example, equity is found by subtracting the amount you owe (also called the "debit balance") from the current market value. In this case, your equity is $5,000, which is due to the $5,000 check you sent in for the trade. You now own $10,000 worth of stock but have only paid $5,000 out-of-pocket toward that purchase and are borrowing the remainder, which is shown by the debit balance. Your broker will charge you interest on that debit balance. Depending on your broker, that interest may accrue each day to that balance or may just be posted at the end of each month. The interest rate charged is called the "broker call" rate. To keep our examples simple though, we will not be adding interest to the calculations.

Equity Percentage

You can always find your equity percentage by dividing your equity by the market value. At this point, your account is at 50% equity, which is found by taking the $5,000 equity and dividing by the $10,000 market value. The concept of equity percentage will be important later when we talk about maintenance calls.

Market Fluctuations

Just like our previous house example, your equity will fluctuate as the market value of the stock fluctuates. Let's assume that the stock price rises by $1,000 to $11,000. Your equity will also increase by the $1,000 gain in the stock:

Market Value = $11,000

- Debit Balance = $5,000

Equity = $6,000

Notice that your equity increased from $5,000 to $6,000. The reason your equity directly increases with a rise in the market value is because the debit balance does not change. (Remember, in the real world of margin trading the debit balance will change increase slightly each day; however, the debit balance is not affected by changes in the stock's price.) The reverse is true too; if the market value dropped by $1,000, then your equity would fall by $1,000 as well:

Market Value = $9,000

- Debit Balance = $5,000

Equity = $4,000

Excess Equity

One nice feature of margin accounts is that they can create additional cash for you to borrow if your stock's value rises. You can use this cash for anything you'd like. The reason you get additional cash is because you're only required to maintain 50% equity. Assuming the market value rises to $11,000, you only need to maintain 50% of that new market value, which is $5,500. Since your equity is $6,000, you have an additional $500 in equity that is not required to be there. This is called "excess equity" but most brokerage firms will show this on your account as "margin cash available," which simply means the amount of cash you're allowed to withdraw from the account at that time. Once again, you can use this cash for anything. You could withdraw it in cash or purchase more stock (it does not have to be the same stock). The accounting is a little different depending on whether you take out cash or buy more stock so let's run through each scenario. First, let's assume you withdraw the $500 cash. Now your account looks like this:

Market Value = $11,000

Debit Balance = $5,500

Equity = $5,500

Notice that your debit balance is increased by the $500 cash since that is an additional loan against your stock. At this point you have $5,500 equity and $11,000 worth of stock so your account remains at 50% equity.

Now let's assume you use that additional cash to buy $1,000 worth of stock. Remember, you can do this since you have a margin account and are only required to pay for half of the trade. Your account would then look like this:

Market Value = $12,000

Debit Balance = $6,000

Equity = $6,000

The debit balance increases from $5,000 to $6,000 and your market value also increases by $1,000 from $11,000 to $12,000. The equity is still 50% since you own $12,000 worth of stock and have $6,000 equity.

In this example, the extra $500 cash allowed you to buy $1,000 worth of stock. In order to show the difference between "cash available" and "money available for buying stock," brokerage firms often show another figure called "buying power," which is simply the dollar amount of stocks you're allowed to buy without having to send in any additional money. Margin cash available is strictly the amount of cash - a check you could withdraw - based on the excess equity in your account. The buying power is the amount of stocks (or other securities) you could purchase based on the excess equity.

Let's recap the account but this time we'll show "margin cash available" and "buying power." You originally purchased $10,000 worth of stock and sent a check for $5,000. Later, the stock rises to $11,000 and your account now looks like this:

Market Value = $11,000

Debit Balance = $5,000

Equity = $6,000

Your account would also show the two fields below (or something similar to it):

Margin Cash Available = $500

Buying Power = $1,000

Whether you withdraw $500 cash or buy $1,000 worth of stock, your account equity will still be 50%.

Restricted Account

If the market value of your stock should drop sufficiently, it is possible that your equity will no longer be 50%. If this happens, the account is called a "restricted account." This just means that you generally can no longer buy stock without having to send in money. Any sales of stock or cash sent to the broker will be used to make up the short fall in cash. So just because you're required to start your account off at 50% equity does not mean that it must stay there. Your equity percent is allowed to fall below 50% without having to send in any money. However, there is a point where that will no longer be true. If the equity percentage continues to fall, at some point your broker will require you to bring the account equity percentage higher by either sending in more money or selling off some stock. When the broker requires you to increase your equity percentage in your account, this is called a maintenance call.

Maintenance Calls

If your account falls below a certain minimum equity percentage, which is usually called the house percentage or house requirement, you will receive a maintenance call and be required to increase the equity percentage in your account. The NYSE (New York Stock Exchange) and NASD (National Association of Securities Dealers) require a minimum of 25% equity; however, most brokerage firms have stricter requirements and usually require between 30% and 35%. Some brokers have different requirements depending on how the account is diversified. For example, if you own one or two stocks, they may require 35% but if you have a well-balanced account, they may allow 30%.

So even though you must initiate the trade with a 50% deposit, your account equity does not need to stay at 50% or higher. The regulatory bodies allow for some slippage due to price fluctuation; however, they only allow it to fall so far - down to the house percent level. The higher the house percent, the less risk there is to the brokerage firm and the more costly it is for you to maintain sufficient equity.

If your account falls below the house percent, you are "in maintenance" and you will receive a "maintenance call" (also called a "house call") from your broker saying that you're required to send in more money - even though you may not have purchased anything. Maintenance calls are a sign that your securities are moving against you and that you need to bring up the equity since it is becoming dangerously low.

Let's assume that your broker requires that you maintain at least 30% equity and that your stock's value has fallen to $7,000. Your account now looks like this:

Market Value = $7,000

Debit Balance = $5,000

Equity = $2,000

Your equity percentage is now $2,000/$7,000 = 28.5%, which is below your broker's minimum 30% requirement. You will receive a maintenance call for the missing equity amount. This can be found by taking the current market value of $7,000 and multiplying it by the house percent of 0.30, which equals $2,100.

There are three basic ways to meet this maintenance call:

  • Deposit Cash
  • Sell Stock (or other assets in the account)
  • Deposit Stock

We'll take a look at all three ways in turn.

Depositing Cash

Since your equity is $2,000 and you are required to have $2,100, we know you could send in a check for the $100 difference. Once you do, your account looks like this:

Market Value = $7,000

Debit Balance = $4,900

Equity = $2,100

The $100 payment goes toward the debit balance, which is reduced from $5,000 to $4,900. Your equity percentage is now $2,100/$7,000 = 30% and your broker is happy - at least for now. Most brokers will disregard maintenance calls of a small amount such as $100 in this example, but they are not required to do so.

If you deposit cash, the maintenance call is reduced dollar-for-dollar, debt is reduced dollar-for-dollar, and equity increases dollar-for-dollar.

Also, most brokers will allow a small window of time to get the maintenance money to them; however, they are not required to do this either. If the maintenance call is severe enough, the broker may start selling stocks until the account meets their minimum requirement without even giving you a phone call or consulting with you as to which stocks or securities you'd prefer to sell. This is because investors borrow individually but brokerage firms loan collectively. The broker will most likely liquidate the security or securities that pose the biggest threat to them - not to you. If you're trading on margin, make sure you keep a close eye on your equity percentage and keep in close contact with your broker when that percentage gets close to maintenance levels.

Another reason for staying in touch with your broker when trading on margin is that they may decide to increase the minimum equity for a particular stock thus placing your account into a maintenance call even though the stock's price hasn't changed. This may happen if there is unusual price fluctuation and the broker isn't comfortable in maintaining their house requirement on that stock. They can just decide one day that they wish to make a particular stock have a 50% requirement. The important point is that it is not enough to just watch the price of your stocks when on margin. You need to make sure the broker can easily contact you if a sudden change in requirements or other situation arises.

Selling Stock to Meet Maintenance Calls

Rather than sending in money to meet the maintenance call, let's assume you decide to sell some stock in order to bring your account back to the 30% house level. We assumed that the account was in maintenance as follows:

Market Value = $7,000

Debit Balance = $5,000

Equity = $2,000

We know that the equity percentage is $2,000/$7,000 = 28%. If you wanted to get your account to 30% by selling stock, you'd need to sell 1/0.30 = 3.33 times as much stock. We know that 30% equity is 0.30 * $7,000 = $2,100 so your equity is $100 short. This means you'd have to sell 3.33 * $100 = $333 worth of stock to get your equity to 30%. Once you do, that cash is subtracted from your market value as well as your debit balance:

Market Value = $6,666

Debit Balance = $4,666

Equity = $2,000

Notice that your $2,000 equity does not change; however, your new equity percentage is $2,000/$6,666 = 30%. By selling stock, all you've changed is the ratio between the market value and debit but it does not change your equity. (In the real world, you will change your equity slightly due to commissions and bid-ask spreads.)

Check with your broker as to their policies on meeting maintenance calls. Some brokers have hybrid rules such as allowing the account to fall to 30% but must be brought back to 35% to meet the maintenance call.

Depositing Stock

You can also meet a maintenance call by depositing stock whether in the form of stock certificates held in a safe deposit box or by transferring them from another broker (or another account within the same broker). Let's assume you bring in a stock certificate for 100 shares and the stock is currently $10. This means the current market value of the certificate is $1,000 so your account equity would increase by this amount as does your equity:

Market Value = $8,000

Debit Balance = $5,000

Equity = $3,000

Your equity is now increased to $3,000/$8,000 = 37.5%

Selling Stock to Meet Fed Calls

We just found out that one of the ways we can meet maintenance calls is by selling stock. However, be careful if you are selling stock to meet a Fed Call. Remember, the Fed Call is the initial 50% requirement. If you decide to sell stock to meet a Fed Call, you must do so on the same day as the purchase. For example, assume you buy $10,000 worth of stock and have thus incurred a $5,000 Fed Call. If you wish to sell $5,000 worth of stock, you must do so on that same day. If you do not, your account is labeled with a "liquidation," which just means that you sold stock to cover a Fed Call after the trade date. If you do this enough times, your broker may make your account a cash-up-front account for 90 days. If another liquidation occurs at a later time, your broker may make your margin account a permanent cash-up-front account.

There is a logical reason for the restrictions on selling stock to meet a Fed Call versus a margin call. Let's say you buy the $10,000 worth of stock and do not have the funds to make the $5,000 Fed Call and decide you will sell some stock to cover the $5,000 Fed Call. However, you decide to wait until the next day to sell that stock. Now let's assume that the value of that stock drops sufficiently to where it does not cover the Fed Call. What appeared to be a good idea now created a problem for you and the broker and this is not a good practice to assure an orderly market. In addition to the risk of a falling stock price, if you sell stock to cover the trade at a later date, the settlement dates do not match and the broker has another short-term problem. To avoid these problems, you must sell the stock on the same day as the trade date if you are doing so to meet a Fed Call. If you are ever unsure, it's best to check with your broker before executing the trade. Incidentally, all Fed Calls must be met regardless of what happens to the price of the stock. The reason is that it keeps traders from speculating with the market's money. If this rule were not in effect, traders could buy large dollar amounts of stock hoping that it goes up. For example, you could put in an order to buy one million shares of Intel and then sell it the next day if it rises. If the stock were to rise $1 the next morning, you'd make $1,000,000 for doing nothing other than speculating with the market. In order to prevent traders from doing this, the regulators would require you to deposit a check (or sell securities) to meet the $500,000 Fed Call just to prove that you have the equity to place those kinds of trades. You must meet all Fed Calls; however, they can be met with the margin cash or buying power in your account.

Special Memorandum Account

In the previous examples, we've assumed that you can withdraw money based on the "margin cash" or "buying power" that is shown in your account. These values are actually based on the excess cash that is tracked in a Special Memorandum Account, or SMA. The "margin cash" and "buying power" act as circuit breakers and keep you from overspending the SMA in the account. The only reason we bring up SMA is because if you should ever transfer your account to another broker, you will lose any SMA in the account that may exist. However, if you request for the SMA to be transferred, it will be transferred to the new broker. Make sure you request for this to be done otherwise you may end up having to send in a lot of money to meet the new 50% requirement at the new firm!

Why Have a Margin Account?

We've seen how buying stocks on margin can provide financial leverage, which can be good and bad. But even if you do not plan to borrow money to buy stocks, there are many good reasons for having a margin account:

The first is that it provides you with a way for a quick loan if you should need it. And because this loan is mostly secured, it will carry a lower interest rate than what you can likely get from a credit card. There's no application or waiting time. You just request a check and you're on your way. Another reason is to float money. Perhaps you have a company bonus coming but wish to buy the stock today. Second, buying on margin is a way to take advantage of today's prices without having the money today. Even though you're borrowing money in this case, it is only to fix a short-term cash flow problem. This is different from someone who buys stock on margin because they don't have the money. In fact, here's another way a margin account can help with cash flows. Assume your margin equity is 100% but that you sell some stock because you just bought a new car today and must get a sizeable check to the car dealer. When you go to get your check, your broker tells you that the cash will not be available for three full business days. (Did you forget about the T+3 settlement period?). However, if you have a margin account, your broker can cut a check that instant and you will pay a modest interest rate for three days until settlement. Margin accounts can really help even if you do not intend to borrow money for long periods.

Third, if you wish to short stocks, you must have a margin account. There's no way around it. Shorting stock is a way to sell stock that you don't own with the hopes of buying it back later at a lower price and profiting from the difference. Shorting allows speculators to take advantage of a downfall in price. We'll cover short selling in the next course, but if you'd like to see an example of how trader's short stock, click here.

Fourth, if you wish to trade futures or options, you must have a margin account.

Downside to Margin Accounts

Despite the benefits of a margin account, there are many dangers you need to be aware of:

  • You can lose more money than what you deposit in the account.
  • Your broker has the right to force the sale of any security in the account if you should fall into maintenance (or if they decide to raise their house requirements).
  • Your broker can sell any security in the account without giving you a phone call.

These are the extreme limits of what can happen in a margin account. In most cases, brokers will let you decide which stock(s) you'd like to sell and will give you some time to deposit more money to the account. Just understand that the broker is under no obligation to do so. That's why it's imperative to stay in touch with your broker if you are near maintenance levels.

Losing More Than You Have

We just said that it is possible to lose more money than what you have into a trade by being on margin. Let's take a look at two investors - one who pays 100% and the other who trades on margin - and compare the results.

Let's say these two traders buy 200 shares of a $50 stock. The first trader pays the full $10,000 in full and therefore has 100% equity in the investment. The margin trader sends in $5,000 and carries a margin balance for the rest. The two traders' accounts look like this:

Cash Trader

Market Value = $10,000

Debit Balance = $0

Equity = $10,000


Margin Trader

Market Value = $10,000

Debit Balance = $5,000

Equity = $5,000

Now let's assume that the stock price drastically drops the next day from $50 to $20. The two accounts now stand as follows:

Cash Trader

Market Value = $4,000

Debit Balance = $0

Equity = $4,000


Margin Trader

Market Value = $4,000

Debit Balance = -$1,000

Equity = $5,000

(Account has negative equity)

The market value of the stock has fallen from $10,000 to $4,000. The cash trader has lost $6,000 equity. However, the margin trader has lost the original $5,000 equity and is now negative equity of $1,000 for a total of $6,000 lost. This means the margin trader must send in $1,000 just to get his equity to zero percent. Both traders have lost $6,000 but the cash trader is still at 100% equity. The margin trader has negative equity. So margin trading does not cause larger total losses; it can cause larger percentage losses. The dangerous point to consider is that the margin trader may not have the money to bring in. However, this is a legally and binding debt just as if it were on your credit card. Don't think you can close the account and walk away from it. The important point to understand is that, if you're trading on margin, it's a good idea to have access to other forms of cash just in case things go wrong. If you're trading on margin simply for the financial leverage, you could get leveraged into some unmanageable losses.

Now, I'm sure that some are thinking that it's not too likely that a stock will take a fall from $50 to $20 in a single day - that's true. Despite the fact that it does happen, it may not be a rational concern for trading on margin. But here's the other side to that argument. Suppose the stock slowly falls on a net basis. Some days it's up and others it's down but, overall, it's in a downtrend. Will you have the psychological strength to take the certain loss and get out of the stock before it becomes a problem? While you may think that you do, most people do not when actually faced with the situation. I have seen numerous traders burn up million-dollar accounts from not wanting to take the for-sure loss. They will hang on to the bitter end just hoping that the stock turns in their favor. And sometimes that doesn't happen. The critical thing to absorb from this example is not whether or not an overnight drop from $50 to $20 is likely but rather to understand that if the stock falls from $50 to $20 in any combination of ways that you will end up with negative equity. If you do not have access to other funds to handle this situation then margin trading may not be your best choice. Understand that any stock price is possible over time.

Buying Multiple Securities

Once you have the understanding of how margin works, the same concept applies to multiple purchases. Suppose you buy $5,000 worth of stock on margin and your account looks like this:

Market Value = $5,000

Debit Balance = $2,500

Equity = $2,500

Now let's assume that you decide to buy $7,000 of another stock tomorrow. All totals are simply combined and you now have $5,000 + $7,000 = $12,000 worth of stock. You also have $2,500 + $3,500 = $6,000 worth of debt. Your account would now look this:

Market Value = $12,000

Debit Balance = $6,000

Equity = $6, 000

The margin account only tracks the totals of all stocks. It does not create a new accounting entry for each purchase. It views the entire account as one "investment" rather than many individual pieces.

How Far Can My Stock Fall?

One critical question option traders have is how far can the stock fall before I get a maintenance call? The answer is easy to figure out. Suppose that your broker has a 30% house requirement and you just bought 100 shares of a $60 stock:

Market Value = $6,000

Debit Balance = $3,000

Equity = $3, 000

The market value of the stock can fall to the debit value divided by complement of 30%, which is simply (1-0.30) = 0.70. The complement of any percentage is the number that makes it sum to 100%. If the broker's house requirement is 35%, then the complement is 1 - 0.35 = 65% since 35% + 65% = 100%.

In this example, the market value could fall to $3,000 debit / 0.70 = $4,285 on 100 shares of stock, or $42.85 per share. If the stock falls to $42.85, your account would look like this:

Market Value = $4,285

Debit Balance = $3,000

Equity = $1,285

You can verify that $1,285/$4,285 = 30%.

Ask Your Broker

Once again, this is a fairly in-depth look at margin trading but is far from everything there is to know. If you decide to trade on margin, it doesn't hurt to ask your broker to run through some "what if" scenarios based on their requirements. Ask questions like:

  • What is your house requirement?
  • How much time do I have to meet a maintenance call?
  • What are the ways I can meet a maintenance call?
  • What is your margin interest rate (broker call rate)?

In addition, ask if there are any online resources or brochures that your broker may offer to learn more about margin trading at their firm. Margin trading can be a very handy and rewarding too if you understand it well. But it can also be financially devastating if you are not aware of all the risks.

One other thing I forgot to mention is deposting stock to cover the call.

If the client deposits cash:

  • it reduces the call dollar-for-dollar.
  • equity increases dollar for dollar; debt decreasese dollar for dollar.

But, if the client deposits stock:

  • Debt is unchanged
  • Equity goes up doallr for dollar
  • MVL goes up dollar-for-dollar
  • Because MVL goes up dollar for dollar the total margin maintenance requirement for the portfolion goes up by .25*MVL of the stock you deposit.
  • That means that only 75% of the value of the stock you deposit can be used to satisfy the maintenance call. This is inevitable because we've increased the the sum of the maintenance requirements of all of the holdings in the portfolio by 25% of the value of the stock the client deposits.

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