Section 11.1: Margin and Cash Accounts

  • Cash Accounts

  • Margin Accounts

  • ⚖️ Two Types of Margin Accounts

Cash Accounts:

  • Definition: The customer must pay the full amount for any securities purchased by settlement date.

  • Settlement: Regular way settlement = T + 1 (trade date + 1 business day).

  • Regulation T (Reg T): Requires payment no later than 2 business days after settlement (S + 2).

  • Examples of accounts that must be cash accounts:

    • IRAs and other retirement plans (due to contribution limits).

    • Custodial accounts (UTMA/UGMA).

Margin Accounts:

  • Definition: The investor borrows part of the purchase price from the broker-dealer (BD).

    • The investor pays part in cash and borrows the rest.

  • Purpose: Allows investors to take larger positions (more buying power) through leverage.

  • ⚖️ Two Types of Margin Accounts

    1. Long Margin Account

      • The customer borrows money from the BD to buy securities.

      • Pays interest on the borrowed money until repaid.

    2. Short Margin Account

      • The customer borrows securities and sells them short.

      • Profits if the price declines.

      • All short sales must be done in margin accounts.

⚙️ Leverage:

  • Using borrowed money or securities to amplify gains or losses.

  • Upside: Higher rate of return if prices move favorably.

  • Downside: Larger losses if prices move against the investor.

💸 Federal Reserve Rules:

  • The Federal Reserve Board (FRB) sets the margin requirement.

  • Investors may borrow up to 50% of the value of securities purchased.

Margin & Cash

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Margin & Cash 〰️

📈 Comparing Cash vs. Margin Accounts

Scenario / Cash Account / Margin Account

  • Buy 1,000 shares @ $20 / Pay $20,000 / Pay $10,000, borrow $10,000

  • Price rises to $30 / Gain $10,000 → 50% return / Gain $10,000 → 100% return

  • Price drops to $15 / Lose $5,000 → 25% loss / Lose $5,000 → 50% loss

🧾 Required Margin Agreements:

  • To open a margin account, three forms are involved:

    • Credit Agreement (mandatory)

      • Discloses the terms of the credit extended by the BD.

      • Includes how interest is computed and when rates may change.

    • Hypothecation Agreement (mandatory)

      • Allows the BD to hold the customer’s securities as collateral for the loan.

      • All margin account securities are held in street name (registered in the BD’s name).

    • Consent to Loan Agreement (optional)

      • Gives the BD permission to loan the customer’s securities to others (often for short sales).

      • Optional by regulation, but some firms require it internally.

⚠️ Risk Disclosure Document:

  • Must be given before opening a margin account.

  • Must be provided annually thereafter.

  • Explains risks such as:

    • Potential for larger losses due to leverage.

    • Possibility of margin calls.

    • The firm’s ability to sell securities without notice if equity drops.

🏦 Account Types Eligible for Margin

  • ✅ Allowed (if documentation permits):

    • Individual accounts

    • Joint accounts

    • Sole proprietorships

    • Corporations (if bylaws/charter allow)

    • Partnerships (if partnership agreement allows)

    • Trusts (only if trust document explicitly allows margin)

  • ❌ Not Allowed:

    • IRAs and other retirement accounts

    • Custodial accounts (UTMA/UGMA)

✺ Review questions ✺

  • A. T+2
    B. T+1
    C. S+2
    D. T+3
    ✅ Answer: B. T+1

  • A. Settlement date
    B. One business day after trade
    C. Two business days after settlement (S+2)
    D. Three business days after settlement
    ✅ Answer: C. S+2

  • A. Corporate account
    B. Individual account
    C. IRA account
    D. Joint account
    ✅ Answer: C. IRA account

  • A. 25%
    B. 50%
    C. 75%
    D. 100%
    ✅ Answer: B. 50%

  • A. Hypothecation and consent to loan
    B. Credit and consent to loan
    C. Credit and hypothecation
    D. Consent to loan and risk disclosure
    ✅ Answer: C. Credit and hypothecation

  • A. The BD to sell the customer’s securities
    B. The BD to loan the customer’s securities to others
    C. The customer to borrow cash
    D. The customer to pledge securities as collateral
    ✅ Answer: B. The BD to loan the customer’s securities to others

  • A. 25%
    B. 50%
    C. 75%
    D. 100%
    ✅ Answer: B. 50%