What is a Margin Account and How is it Different from a Cash Account?

A Margin Account is a special type of brokerage account which is designed to permit investors to borrow money to buy securities. The loan is secured by securities in the account. Investors generally use margin to increase their purchasing power so that they can own more stock without fully paying for it. The use of margin exposes Clients to the potential for higher losses.

A Cash Account is simply a brokerage account in which the investor must pay for the securities purchased within a limited period of time [as opposed to borrowing the money from the brokerage house]. It is possible for an investor to borrow money from other sources and then use the money to buy stocks in a Case Account, but this is rarely done. If the intention is to borrow money to buy stocks, the normal device is the Margin Account.

The establishment of a Margin Account requires the investor's agreement and prior approval in writing of a Margin Disclosure Statement that discusses the risks of margin. The Interest Charges associated with the borrowing of money in the Margin Account must be clearly defined. At times, the interest rates associated with the use of a margin may be considerably higher than interest rates from other sources.

The Federal Reserve Board requires that before new stocks can be purchased in a Margin Account, the debt-to-equity ratio must be at least 50 percent. This is called the Initial Margin Requirement. For example, starting from scratch, with $5,000 in the Margin Account, an investor can buy $10,000 in securities.

What is Buying Power?

Buying Power is the amount of securities you can buy on margin. You must have sufficient buying power in your account when entering a margin order. The amount of Buying Power fluctuates from day-to-day. Buying power is generally calculated as:

(Margin Free Cash + / - Certain Pending or Unsettled Transaction) x 2 = Buying Power

To calculate Margin Free Cash, the margin debit is subtracted from the total value of securities in the Margin Account to get the equity. The securities positions as of the previous market close are used for the calculation. If the equity exceeds the firm's Maintenance Margin Requirements, additional securities may be purchased on margin.

The Maintenance Margin is the amount a client needs to maintain after trades. These amounts are set by the Federal Reserve Board, as well as by individual brokerages. Individual brokerages may have stricter limits, but the Federal Reserve Board sets a minimum initial margin of 50% and a maintenance margin of at least 25%.

Example:

Market Value - Debit = Equity

Equity - (Current Market Value x Firm's Margin Requirement) = Excess Equity (Margin Free Cash) x 2 = Buying Power

What is the Special Memorandum Account (SMA)?

The Special Memorandum Account (SMA) is a notation on a customer's margin account. Funds are credited to the SMA on a memo basis, and the SMA is used much like a line of credit with a bank. The SMA preserves the customer's right to use Excess Equity. Excess Equity determines the total amount of new securities that can be purchased in a Margin Account, or the Buying Power in the account. Buyer Power is 2 times the amount of Excess Equity.

If SMA as calculated under Regulation T is lower than excess equity, then margin free cash is equal to SMA.

Only securities bought in the Margin Account count toward buying power. Securities held in a Cash Account are not considered for margin Buying Power.

What is a Margin Call?

The Federal Reserve Board mandates that brokerage houses enforce a Maintenance Margin Requirement whereby the value of the equity must be at least 25 percent of the margin debit. If the ratio of debit to equity exceeds this amount, securities must be liquidated to raise the ratio in the account or additional cash must be deposited. The brokerage house has the absolute right to sell securities in the account to pay down the margin debit. The brokerage house can also require the investor to deposit additional cash so that securities will not be sold. When additional cash is required, this is known a Margin Call. If the investor does not deposit the cash as required, securities will be sold by the firm to raise the necessary cash.

Can a Brokerage House Change the Maintenance Margin Requirements?

Brokerage houses have the right to raise the Maintenance Margin Requirements higher than the minimum of 25 percent set by the Federal Reserve Board. A brokerage house may do this in order to protect its own interests in a volatile market. Thus, is it possible for a brokerage house to force a Margin Call or require that securities be sold, by raising the Maintenance Margin Requirements.

What is being "Wiped Out?"

Many times it has happened that unsophisticated investors have invested on margin without fully understanding how the margin rules work. If such an investor purchases volatile securities it is possible for 100% of the money in the account to be lost when a firm liquidates the account in order to raise cash to pay down the margin debit. This is also known as being Wiped Out. Being Wiped Out may and often does mean that not only will the investor owe money to the firm to pay of the outstanding balance on the margin loan. It is also possible to have large tax consequences generated from the activity in the account prior to the Wipe Out.

What are the Risks of Investing on Margin?

A conservative investor should never invest on margin. The use of margin is normally a form of speculation in which the investor bets that the securities purchased will move up in value rapidly. If this happens, larger gains can be achieved. However, the reverse is true if the value of the securities drops rapidly. Larger losses can be suffered. Margin accounts can be very risky because:

The effect of market volatility is increased.

It is possible to lose 100% of the capital in the account and still owe money to the brokerage house.

Substantial interest charges can be incurred.

If the net equity in the account drops below the Maintenance Margin Requirements, the account may be liquidated without notice, locking in losses.

Why Do Brokers So Often Recommend the Use of Margin?

Stockbrokers often encourage investors to use margin despite the serious risks because the use of margin increases the dollar value of the trading of the broker's clients. Brokers usually receive a percentage of the margin interest as additional compensation. There are normally rewards given to the brokers who have the greatest volume of trading in their client accounts. These high selling brokers may be admitted into exclusive sales clubs with names such as the "President's Club" or "President's Council," and these names are normally given by firms to those brokers who have the largest sales volume. There may be all expense paid vacations or other benefits given to this elite group of brokers. Of course, since brokers are normally paid commissions, these brokers also earn more annual compensation because their clients use margin. They may also be entitled to bonuses or other perks.

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