Margin is borrowing money from a broker-dealer to purchase securities. Instead of paying 100% of a security's purchase price, you pay a portion (your equity) and borrow the rest from the firm. Your securities serve as collateral for the loan.
Real-world analogy: Buying on margin is like buying a house with a mortgage. You put 20% down (your equity) and the bank finances the remaining 80% (the loan). You own the house but owe the bank. If the house rises in value, your return on your equity investment is amplified. If it falls, you can lose more than your down payment.
Margin amplifies both gains and losses -- it is a double-edged sword.
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Regulation T (Reg T), issued by the Federal Reserve Board, sets the initial margin requirement for purchasing equity securities.
Reg T initial margin = 50%
This means you must deposit at least 50% of the purchase price in cash (or marginable securities). The broker lends you the remaining 50%.
Example: You want to buy $20,000 worth of stock on margin.
Buying power: With $10,000 in cash, your buying power is $20,000 (cash divided by 50% Reg T requirement). Every dollar in your account supports $2 of stock purchases.
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Once a position is established, maintenance margin requirements apply. These are the minimum equity levels you must maintain:
Note: Most broker-dealers impose higher "house" maintenance requirements (often 30-35% long) above FINRA minimums.
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When does a margin call trigger? When your equity falls below the maintenance margin requirement.
For a long position:
Example: You bought $20,000 of stock, borrowed $10,000 (debit balance = $10,000). Maintenance = 25%.
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When a margin call is issued, the customer must PROMPTLY: 1. Deposit additional cash or marginable securities 2. Or the broker may liquidate securities in the account without prior notice
Broker's right to liquidate: The margin agreement (signed at account opening) grants the broker the right to sell securities in the account without contacting the customer first if a margin call is not met. The broker chooses WHICH securities to sell.
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Short selling is selling a security you do not own -- borrowing it from a broker-dealer to sell, with the obligation to buy it back later and return it.
Profit mechanism: Short seller profits if the stock declines. 1. Borrow 100 shares of XYZ from the broker; sell at $50 = $5,000 proceeds 2. Stock falls to $35; buy 100 shares at $35 = $3,500 3. Return shares to broker; profit = $5,000 - $3,500 = $1,500
Loss risk: If XYZ rises to $80, you must buy at $80 = $8,000 to close = $3,000 loss. Theoretically unlimited -- the stock could keep rising.
Short selling requirements:
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The Special Memorandum Account (SMA) represents excess margin in the account -- the amount by which the account equity exceeds the Reg T 50% requirement.
SMA is like a line of credit: it can be used to buy additional securities or withdrawn as cash (up to certain limits). SMA is generated when:
SMA does NOT decrease when stock prices fall (it is a "high water mark" record). However, using SMA to buy more stock creates a new Reg T requirement on the new purchase.
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Pattern Day Trader (PDT): A customer who executes four or more day trades within five business days, provided those day trades represent more than 6% of total trading activity.
Day trade = buying and selling (or selling short and covering) the same security on the same day.
PDT minimum equity requirement: $25,000 must be maintained in the margin account at ALL TIMES. If the balance falls below $25,000, no further day trading is permitted until the balance is restored.
PDT accounts receive 4x intraday buying power (vs. the normal 2x for overnight positions).
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The broker charges interest on the borrowed amount (the debit balance). Interest accrues daily and is typically charged monthly. The rate is usually based on a broker call rate plus a markup.
This cost reduces the profitability of margin trading. A 6% annual interest rate on a $10,000 debit balance costs $600/year -- the stock must gain at least 3% on a $20,000 position just to break even on borrowing costs.
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Quiz Questions:
Q1. An investor wants to purchase $40,000 of stock on margin. Under Regulation T (50%), how much must the investor deposit?
A) $10,000 B) $20,000 C) $25,000 D) $40,000
Answer: B -- Regulation T requires a 50% initial margin deposit. 50% of $40,000 = $20,000. The broker will lend the remaining $20,000. The investor's debit balance (loan) will be $20,000, and initial equity = $20,000 (50% of market value).
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Q2. An investor bought $30,000 of stock on margin, depositing $15,000 (Reg T 50%). The stock's value has declined to $22,000. The broker's maintenance margin requirement is 25%. Is the investor subject to a margin call?
A) No, because the equity is still positive B) Yes, because equity ($7,000) is below 25% of $22,000 ($5,500) -- wait, equity exceeds requirement, so no call C) Yes, because equity ($7,000) is below 25% of market value -- no, $7,000 / $22,000 = 31.8%, above 25% D) No, because equity of $7,000 is 31.8% of market value, above the 25% maintenance requirement
Answer: D -- Debit balance = $15,000 (unchanged; it is the loan). Market value = $22,000. Equity = $22,000 - $15,000 = $7,000. Equity % = $7,000 / $22,000 = 31.8%. Since 31.8% > 25% maintenance requirement, no margin call yet. The call triggers when equity / market value falls below 25%.
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Q3. Under the pattern day trader rule, a customer who is classified as a pattern day trader must maintain a minimum account equity of:
A) $2,000 B) $10,000 C) $25,000 D) $50,000
Answer: C -- FINRA Rule 4210 requires pattern day traders to maintain a minimum of $25,000 in their margin accounts at all times. If the balance falls below this threshold, the customer cannot make further day trades until the account is restored to $25,000. This requirement is significantly higher than the standard $2,000 minimum margin account requirement.
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Q4. An investor short-sold 200 shares of ABC at $60 per share. The current price of ABC is $75. If the maintenance margin requirement for short positions is 30%, is there a margin call?
A) No, the position is profitable and no call is required B) Yes, a margin call may be issued because the stock has risen above the short sale price C) No, maintenance margin does not apply to short positions D) Yes, but only if the investor requests a margin review
Answer: B -- When a short seller's position moves against them (stock rises), their equity decreases and the maintenance margin requirement as a percentage of the rising market value increases. Original proceeds: 200 shares x $60 = $12,000. Reg T 50%: deposited $6,000. Current market value: 200 x $75 = $15,000. Equity = $12,000 + $6,000 - $15,000 = $3,000. 30% maintenance on $15,000 = $4,500. Equity ($3,000) < requirement ($4,500) = margin call.
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Q5. Which of the following BEST describes the broker-dealer's right when a margin call is not promptly met?
A) The broker must obtain a court order before liquidating any securities B) The broker may liquidate securities in the account without prior notice to the customer C) The broker may only liquidate securities with the customer's written consent D) The broker must issue a second margin call before taking any action
Answer: B -- The margin account agreement (signed at account opening) grants the broker the explicit right to liquidate securities in the account without notifying the customer in advance when a margin call is not met. The broker selects which securities to sell. This is a standard provision in all margin agreements and is specifically tested on the Series 7. There is no requirement for court orders, written consent, or multiple calls before liquidation.