Margin Accounts Based on May 2005 AAII Article by John Gannon OMEGA Investment Club 

What is a Margin Account? ΩBorrow money from broker to purchase stock(s) ΩYou must repay the borrowed amount, plus interest

Margin Costs Ω“Cost” = Interest ΩRates generally vary based on: “Broker Call Rate” aka “Call Money Rate” Amount borrowed Firm to Firm ΩCan find rates for most brokers in WSJ under “Money Rates”

Who Profits ΩOmega could profit if stock does well but usually… ΩBrokerage Firm - Interest ΩBroker –May receive percentage of interest

Margin Requirements ΩThis brief does not apply to: Day trading Shorts Other types of securities

Initial Margin ΩMust have a minimum of $2,000 in account ΩYou can borrow up to 50% of the total purchase price of a stock of a new (initial) purchase ΩIf 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 ΩEquity in the account must not fall below 25% of the current market value of the stocks ΩIf it does, you receive a “Maintenance Margin” that requires a deposit to maintain the 25% level ΩFailure to meet call forces liquidation of stocks

House (Brokerage) Requirements ΩFirms have the right to set their own reqts ΩIf stocks are volatile, they can raise maintenance margin reqts ΩBrokerage 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

Example ΩDay 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 ΩDay 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 ValueMargin Shareholder’s Equity (Acct Val – Loan) Minimum Maintenance Margin Day 1$100$100K$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 #1 ΩMr. 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 ΩEach stock has a 25% maintenance margin reqt ΩMr. Jones has a $6,000 unmet maint margin call ΩBroker sells GHI to meet the call ΩMr. Jones is PO’d. Why didn’t the broker sell DEF?

Partial Sellouts – Example #2 ΩMs. 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 ΩMs. Smith has a $2,200 unmet maint margin call ΩBroker sells JKL to meet the call ΩWhy didn’t the broker sell PQR?

Partial Sellouts Answer ΩCustomers borrow individually but brokers lend collectively ΩBrokers are concerned with overall financial exposure ΩGHI and JKL represented the greatest financial risk to the broker

Summary of Risks ΩBrokerage can force sale of stocks to meet a margin call ΩSale can happen without notification Often in poor market conditions Not entitled to choose which stocks are sold ΩBrokerages often have House Reqts above SEC ΩBrokerage can increase margin requirements at any time without notice ΩNo extension of time ΩYou can lose more money than what’s in the account