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Let's talk about margin accounts. I know, I know. It’s one of those topics on the Series 7 exam that can feel like a mess of percentages and rules. You might see a question like: 'A customer buys twenty thousand dollars of stock on margin, the stock drops, then they sell some shares... what's the SMA and buying power?' It can seem complex. But once you understand the logic, it's actually very straightforward. It's all about tracking the numbers and knowing the key rules.
A margin account allows you to use leverage. You put some of your own money down, and the broker-dealer lends you the rest to buy securities. This leverage can amplify your gains, but it also amplifies your losses. Because there's borrowed money involved, regulators have specific rules to manage the risk. The two main regulators here are the Federal Reserve and FINRA.
The first key rule comes from the Federal Reserve Board. It’s called Regulation T, or just Reg T. This rule governs the initial purchase. It says that for most stocks bought on margin, you must deposit at least 50% of the purchase price. For example, to buy ten thousand dollars' worth of stock, you need five thousand dollars of your own money. The other five thousand is borrowed from your broker. That borrowed amount is called your debit balance. It's your loan.
Now, there are a couple of small-dollar exceptions. If you're buying something on margin that costs between two and four thousand dollars, you must deposit a flat two thousand dollars. If it's less than two thousand dollars, you have to pay for the entire thing in cash. One hundred percent. But for any purchase over four thousand dollars, it's that clean 50% Regulation T rule.
Okay, so you've made the trade. When do you actually have to pay? Regulation T is very specific, and this is a huge exam point. The deadline is tied to the settlement date. Stock trades now settle in one business day, which we call T plus 1. The payment deadline is two business days after settlement. So, S plus 2. If you do the math, that means you have to pay by the third business day after the trade date. T plus 3. Don't let them trick you with old rules. It's T plus 3. If you don't pay, the firm must sell you out of the position.
And a quick aside: if you sell a security before you've paid for it, that's a violation called 'freeriding'. If that happens, your account gets frozen for 90 days. So these payment deadlines are taken very seriously.
Regulation T gets you in the door. But what about keeping the account in good standing? That's where FINRA, the Financial Industry Regulatory Authority, comes in with its own rules. This is your maintenance requirement. It’s the rule that prevents your account from losing too much value if the market turns against you.
For a long position, FINRA requires you to maintain equity of at least 25% of the current market value. If your equity drops below that 25% line, you'll receive a maintenance call. This is a demand from your broker to deposit more money or securities immediately.
For short positions, the maintenance requirement is higher, at 30% of the market value. FINRA also has a minimum equity rule. You must always have at least two thousand dollars of equity in a margin account. If it dips below that, you'll get a call to bring it back up to two thousand.
Now, let's talk about what happens when your stocks do well. When the value of your portfolio goes up, your equity grows. If your equity grows to be more than the 50% Regulation T requirement, you generate something called SMA, which stands for Special Memorandum Account.
It's very important to remember that SMA is not cash. Think of it as a line of credit. It's a memo entry on your account that tracks your excess borrowing power. Let's say your ten-thousand-dollar stock portfolio grows to fifteen thousand dollars. Your loan is still five thousand. So your equity is now ten thousand. The Regulation T requirement on a fifteen-thousand-dollar portfolio would be seventy-five hundred. Since your equity of ten thousand is twenty-five hundred dollars above that requirement, you've just generated twenty-five hundred dollars of SMA.
You can also generate SMA in other ways. Depositing cash into your account creates SMA dollar-for-dollar. Receiving a cash dividend does the same thing. And if you sell stock, 50% of the sale proceeds are credited to your SMA.
So what can you do with this SMA.? Two things. You can borrow it as cash, dollar-for-dollar. Or, you can use it as 'buying power' to purchase more securities. Because of the 50% Regulation T rule, every one dollar of SMA gives you two dollars of buying power. That twenty-five hundred in SMA from our example? You could use it to buy another five thousand dollars' worth of stock on margin.
And here’s the most tested feature of SMA. Market declines do not reduce it. Once SMA is generated, it stays on your account. The only way SMA goes down is if you actually use it, either by withdrawing cash or by buying more stock.
This brings us to the idea of a 'restricted' account. An account is restricted if your equity drops below the 50% Regulation T level, but it's still above the 25% maintenance floor. You are not getting a margin call yet. You're in a middle zone. In a restricted account, you can't simply withdraw cash. But if you sell stock, you can free up some money. The rule is that 50% of the sale proceeds must be used to pay down your loan—your debit balance. The other 50% gets credited to your SMA, giving you some buying power back.
Okay, let's walk through an exam-style question together, step by step.
A customer buys 400 shares of XYZ at $50 a share on margin. The stock then drops to $40. Then, the customer sells 100 of those shares at that new price of $40. What's the equity, SMA, and buying power?
Let's take it piece by piece.
First, the initial purchase. 400 shares at $50 is a $20,000 purchase. Regulation T is 50%, so the customer put in $10,000 in equity and borrowed the other $10,000. That $10,000 loan is the debit balance.
Next, the market drops. The stock is now $40 a share. The 400 shares are now worth $16,000. What’s the equity? It's the market value minus what you owe. So, $16,000 minus the $10,000 debit balance. The equity is now $6,000. The account is restricted, because that $6,000 in equity is less than 50% of the market value, which would be $8,000. But it's still well above the 25% maintenance level, so no margin call.
Now for the sale. The customer sells 100 shares at $40. That's $4,000 in proceeds. Remember the rule for a restricted account? Half of the proceeds must pay down the loan, and half goes to SMA. So, the $10,000 debit balance is reduced by $2,000. The new debit balance is $8,000. And, we generate $2,000 of SMA.
So where do we stand? The customer has 300 shares left, still worth $40 each. That's a market value of $12,000. The debit balance is now $8,000. The current equity is twelve thousand minus eight thousand, which is $4,000. The SMA we just generated is $2,000. And the buying power is always two times SMA, so that’s $4,000. Not so bad when you just follow the money.
Let’s try one more. A customer has a long margin account with a market value of eight thousand dollars. Their debit balance is four thousand dollars. How much cash can they withdraw?
First, let's find the equity. That's market value minus the debit balance. Eight thousand minus four thousand gives us an equity of four thousand dollars.
Next, we need to see if there's any excess equity. The Regulation T requirement is 50% of the market value. 50% of eight thousand dollars is four thousand dollars.
The customer's equity is exactly at the Regulation T requirement. There is no excess equity.
SMA is created by excess equity. Since there is no excess equity, the SMA balance is zero.
You can only withdraw cash up to the amount of available SMA. Because the SMA is zero, the customer cannot withdraw any cash. The answer is zero dollars.
The biggest trap on the exam is mixing up the percentages. So let's review the key takeaways.
First, Regulation T sets the initial requirement at 50%. FINRA sets the maintenance requirement for long positions at 25%.
Second, the payment deadline for a new purchase is T plus 3. That's three business days after the trade date.
Third, SMA is your line of credit. It gives you two-to-one buying power and is not reduced by market declines.
And fourth, a restricted account is not in a maintenance call. It's just an account where equity has fallen below the 50% Regulation T level.
You've got this. Just take it one step at a time.
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