Subject: Trading - Brokerage Account Types
Last-Revised: 23 Jul 2002
Contributed-By: Rich Carreiro (rlcarr at animato.arlington.ma.us), Chris Lott (contact me), Eric Larson
A cash account is the traditional brokerage account (sometimes called a "Type 1" account). If you have a cash account, you may make trades, but you have to pay in full for all purchases by the settlement date. In other words, you must add cash to pay for purchases if the account does not have sufficient cash already. In sleepier, less-connected times than the year 2002, most brokerage houses would accept an order to buy stock in a cash account, and after executing that order, they would allow you to bring the money to settle the trade a few days later. In the age of internet trading, however, most brokers require good funds in the account before they will accept an order to buy. Just about anyone can open a cash account, although some brokerage houses may require a significant deposit (as much as $10,000) before they open the account.
A margin account is a type of brokerage account that allows you
An option account is a type of brokerage account that allows you to trade stock options (i.e., puts and calls). To open this type of account, your broker will require you to sign a statement that you understand and acknowledge the risks associated with derivative instruments. This is actually for the broker's protection and came into place after brokers were successfully sued by clients who made large losses in options and then claimed they were unaware of the risks. It's my understanding that otherwise an option account is identical to a margin account.
Please don't confuse the type of account with the stuff in your account. For example, you will almost certainly have a bit of cash in a brokerage account of any type, perhaps because you received a dividend payment on a share held by your broker. This cash balance may be carried along as pure cash (and you get no interest), or the cash may be swept into a money market account (so you get a bit of interest). Presumably if you have a margin account, the cash will appear there and not in your cash account (see below for more details). It's an unfortunate fact that the words are overloaded and confusing.
Margin accounts are the most interesting, so next we'll go into all the gory details about those.
Access to margin accounts is more restrictive when compared to cash accounts. When you ask for a margin account, your broker will (if he or she hasn't already) run a credit check on you. You will also have to sign a separate margin account agreement. The agreement says that the broker can use as collateral any securities held in the margin account whenever you have a debit balance (i.e., you owe the broker money). Note that if you have a cash account with the same broker, securities held in the cash account (often non-marginable securities) do not help (nor can the broker sell them) if you have a debit balance in the margin account. Conversely, securities in the cash account do not count towards margin requirements.
Another key feature of the margin account agreement is the "hypothecation and re-hypothecation" clause. This clause allows the broker to lend out your securities at will. So the ability to borrow money always comes with the trade-off that the broker can lend out ("hypothecate") securities that you hold to short-sellers. Although you will pay the brokerage when you borrow money from them, the brokerage house will *not* pay you (or in fact even notify you) if they borrow your shares. This seems to be just the way things work. Also see the article elsewhere in this FAQ about short selling for more information.
As a general rule, a margin account will have all marginable securities, and a cash account will have all non-marginable securities. At some brokerage houses, non-marginable securities can be held inside a margin account (Type-2); however, those securities will not be included in the calculation of margin buying power. The insidious element here is that even though the non-marginable securities contribute nothing of value to the margin calculation, those same securities -- if there is even $1 of debit balance in the margin account -- will become registered as "type-2" by virtue of simply residing within a Type-2 acount, and, thus, can be made lendable to brokers for clients wishing to short-sell the stock.
Having a margin account makes it possible to take a margin loan. You can use a margin loan for anything you want. The primary uses are to buy securities (called "buying on margin") or to extract cash from an equity position without having to sell it (thus avoiding the tax bite or the chance of missing a run-up). Some brokers will even give you debit cards whose debit limit is equal to your maximum margin borrowing limit (which is determined daily).
The terms under which you borrow the money (i.e., the interest rate you must pay and the payment schedule) are determined by your portfolio. Subject to various rules on the amount you can borrow (discussed later), you just buy some securities and a loan will be automatically be extended to you. Or if you need cash, you just tell your broker to send you a check or you can use your margin account debit card. The interest rate charged is rather low. It is usually 0-2% above the "broker call rate" (which is usually at or below prime) quoted in the WSJ and other papers. It can change monthly, and possibly more often, depending on the details of your margin account agreement. It is probably lower than the rate on any credit card you'll be able to find. Further, there is no set payment schedule. Often, you don't even have to pay the interest. However, your margin account agreement will probably say that the loan can be called in full at any time by the broker. It will probably also say that the broker can demand occasional payments of interest. Your agreement will also give the broker the right to liquidate any and all securities in your margin account in order to meet a margin call against you.
The interest rate is so low because the loan is fairly low-risk to the broker. First, the loan is collateralized by the securities in your margin account. Second, the broker can call the loan at any time. Finally, there are rules that set your maximum equity to debt ratio, which further protects your broker. If you fall below the requirements, you will have to deposit cash or securities and/or liquidate securities to get back to required levels.
So you probably understand that it could be useful to get cash out of your account without having to sell your holdings, but why would you want to borrow money to buy more securities? Well, the reason is leverage. Let's say you are really sure that XYZ is going to go up 20% in 6 months. If you put $10000 into XYZ, and it performs as expected, you'll have $12000 at the end of six months. However, let's say you not only bought $10000 of XYZ but bought another $10000 on margin, and paid 8% interest. At the end of 6 months the stock would be worth $24000. You could sell it and pay off the broker, leaving you with $14000 minus $400 in interest = $13600 which is a 36% profit on your $10000. This is significantly better than the 20% you got without margin.
But keep in mind what happens if you are wrong. If the stock goes down, you are losing borrowed money in addition to your own. If you buy on margin and the stock drops 20% in 6 months, it'll be worth $16000. After paying off the debit balance and interest you'd be left with $5600, a 44% loss as compared to a 20% loss if you only used your own money. Don't forget that leverage works both ways.
The amount you can borrow depends on the two types of margin requirements -- the initial margin requirement (IMR) and the maintenance margin requirement (MMR). The IMR governs how much you can borrow when buying new securities. The MMR governs what your maximum debit balance can be subsequently.
The IMR is set by Regulation T of the Federal Reserve Board. It states the minimum equity to security value ratio that must exist in your account when buying new securities. Right now it is 50% of marginable securities. This number has been as low as 40% and as high as 100% (thus preventing buying on margin). What this means is that your equity has to be at least 50% of the value of the marginable securities in your account, including what you just bought. If your equity is less than this, you have to put up the difference.
The definition of marginable stock varies from one brokerage house to another. Many consider any listed security priced above $5 to be marginable, others may use a price threshold of $6, etc.
Let's look at an example. If you have $10000 of marginable stock in your account and no debit balance [thus you have $10000 in equity -- remember that MARKET VALUE = EQUITY + DEBIT BALANCE, a variant of the standard accounting equation ASSETS = OWNER'S CAPITAL + LIABILITIES], and buy $20000 more, your market value including the purchase is $30000. Your initial required equity is 50% of $30000, or $15000. However, you only have $10000 in equity, so you have a $5000 equity deficit. You could send in a check for $5000 and you'd then be properly margined.
Let E and MV be equity and market value immediately after the purchase, respectively (but before you make arrangements to be properly margined). Let the equity deficit ED be the difference between the required equity (which is MV*IMR) and current equity (E). Let E1 and MV1 be equity and market value, respectively, after making arrangements to be properly margined. The initial requirement means that E1/MV1 >= IMR. Let C, S, and L be the amount of a cash deposit, a securities deposit, and a securities liquidation, respectively.
- You deposit cash:
E1 = E + C
MV1 = MV
So you need to solve (E+C)/MV >= IMR for C.
- You deposit securities:
E1 = E + S
MV1 = MV + S
So you need to solve (E+S)/(MV+S) >= IMR for S.
- You sell securities:
E1 = E
MV1 = MV - L
So you need to solve E/(MV-L) >= IMR for L.
Using ED [which we previously defined as (IMR*MV - E)], the answers are:
- C = ED
- S = ED/(1-IMR)
- L = ED/IMR
If ED is negative (you have more equity than is required), then that makes C, S, and L negative, meaning that you can actually take out cash or securities, or buy more securities and still be properly margined.
So, now you know how much you can borrow to buy securities. Having bought securities there is now a MMR you have to continue to meet as your market value fluctuates or you pull cash out of your account. The MMR sets the minimum equity to market value ratio that you can have in your account. If you fall below this you will get a "margin call" from your broker. You must meet the call by depositing cash and/or securities and/or liquidating some securities. If you do not, your broker will liquidate enough securities to meet the call. The MMR is set by individual brokers and exchanges. The MMR set by the NYSE is 25%. Most brokers set their MMR higher, perhaps 30% or 35%, with even higher MMRs on accounts that are concentrated in a particular security.
The MMR calculations are very similar to the IMR calculations. In fact, just substitute MMR for IMR in the above equations to see what you'll have to do to meet a margin call. However, here a negative ED does NOT necessarily imply that you can make withdrawals -- the IMR rules govern all withdrawals (though the Special Memorandum Account (SMA) adds some flexibility).
For more details and examples of margin accounts, see the FAQ article about margin requirements.
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