Margin AccountsBased on May 2005 AAII Article by John Gannon

OMEGA Investment Club

What is a Margin Account?

Ω Borrow money from broker to purchase stock(s)

Ω You must repay the borrowed amount, plus interest

Margin Costs

Ω “Cost” = Interest

Ω Rates generally vary based on:• “Broker Call Rate” aka “Call Money Rate”• Amount borrowed• Firm to Firm

Ω Can find rates for most brokers in WSJ under “Money Rates”

Who Profits

Ω Omega could profit if stock does well but usually…

Ω Brokerage Firm - Interest

Ω Broker –May receive percentage of interest

Margin Requirements

Ω This brief does not apply to:• Day trading• Shorts• Other types of securities

Initial Margin

Ω Must have a minimum of $2,000 in account

Ω You can borrow up to 50% of the total purchase price of a stock of a new (initial) purchase

Ω If you do not have enough money to cover your part of the purchase, you receive a “Margin Call” to deposit your part of the purchase

Maintenance Margin

Ω Equity in the account must not fall below 25% of the current market value of the stocks

Ω If it does, you receive a “Maintenance Margin” that requires a deposit to maintain the 25% level

Ω Failure to meet call forces liquidation of stocks

House (Brokerage) Requirements

Ω Firms have the right to set their own reqts

Ω If stocks are volatile, they can raise maintenance margin reqts

Ω Brokerage may not even allow purchase of certain stocks

• Stocks may change immediately based on market conditions and a margin call is issued

• If call is not answered, brokerage can liquidate stocks

ExampleΩ Day 1 – Buy $100K using margin acct

• 1,000 shares of XYZ at $100/sh• Must deposit initial margin of at least 50%, or $50K• Receive margin loan of $50K

Ω Day 2 (Bad day) - Total value falls to $60K• Margin loan = $50K• Equity goes from $50K down to $10K• Min reqts are to have at least 25%, so a margin call is

issued to $5K• If call not met, firm can liquidate stocks

Example

Share Price

Value MarginShareholder’s Equity

(Acct Val – Loan)Minimum Maintenance

Margin

Day 1 $100 $100K $50K $50K $25K

Day 2 $60 $60K $50K $10K$5K is added to acct to bring

up minimum to

$15K

Don’t forget there’s still interest on the loan too

?? Example Note ??

“Because of the way the margin rules operate, if the firm liquidated securities in the account to meet the maintenance margin call, it would need to liquidate $20,000 of securities.”

Partial Sellouts – Example #1Ω Mr. Jones owns three stocks on margin:

• $30K of ABC - substantial long-term gain• $30K in DEF – substantial loss that could be used to

offset gains• $30K in GHI - short-term gain

Ω Each stock has a 25% maintenance margin reqtΩ Mr. Jones has a $6,000 unmet maint margin callΩ Broker sells GHI to meet the callΩ Mr. Jones is PO’d. Why didn’t the broker sell

DEF?

Partial Sellouts – Example #2Ω Ms. Smith has three stocks

• $10K in JKL - Stable stock - house requires 25% maint. margin

• $10K in MNO - More volatile, house sets 40% maint. margin

• $10K in PQR - Volatile in recent months, house sets 75% maint. margin

Ω Ms. Smith has a $2,200 unmet maint margin callΩ Broker sells JKL to meet the callΩ Why didn’t the broker sell PQR?

Partial Sellouts Answer

Ω Customers borrow individually but brokers lend collectively

Ω Brokers are concerned with overall financial exposure

Ω GHI and JKL represented the greatest financial risk to the broker

Summary of RisksΩ Brokerage can force sale of stocks to meet a margin

callΩ Sale can happen without notification

• Often in poor market conditions• Not entitled to choose which stocks are sold

Ω Brokerages often have House Reqts above SECΩ Brokerage can increase margin requirements at any

time without noticeΩ No extension of timeΩ You can lose more money than what’s in the

account