Option traders need to be aware of margin account procedures because SEC regulations require some option strategies to be established in margin accounts. The following overview merely summarizes margin accounts and related terms.A cash account is an account at a brokerage firm in which all purchases are fully paid for in cash. In a margin account, the brokerage firm may lend money to the customer to finance certain types of positions
called marginable transactions.
Different types of marginable transactions, according to regulations, require different amounts of equity capital from the customer. This equity capital is called a margin deposit or, simply, margin.For example, the account equity balance of an investor who purchases stock “on margin” will be less than the value of the stock. The brokerage firm lends the balance of the purchase price to the investor,who, of course, pays interest on the loan.
The use of margin debt will have a significant impact on an investor because market fluctuations will change the account equity balance at a greater percentage rate than the same fluctuation would cause in the equity balance of a cash account. This is called leverage.In this transaction, the brokerage firm borrows stock on behalf of the customer, who sells it at the current market price with the hope of buying it back later at a lower price.
The stock loan is “repaid” with purchased shares when the short stock position is covered. In a short stock transaction,the customer actually pays nothing when initiating the position (except commissions), but the brokerage firm will require a margin deposit to guarantee that the customer will cover any potential losses.Some option transactions are marginable transactions, and some are not.
Also, certain option transactions are required to be conducted in a margin account, and others may be conducted in either a cash account or a margin account. Before engaging in option transactions,an investor should be thoroughly familiar with the type of account required for the transactions that are planned. A simple formula to remember is Account equity margin debt account value Account value is the total market value of owned securities.
The margin debt is the loan to the investor from the brokerage firm, and the account equity is the investor’s share after the securities are sold and margin debt is repaid. Initial Margin, Minimum Margin, Maintenance Margin, and Margin Call Initial margin is the minimum account equity required to establish a marginable transaction. Initial margin requirements are frequently expressed in percentage terms of the market value of a position or its underlying security.
Purchasing stock, for example, is a marginable transaction that currently has an initial margin requirement of 50 percent:Purchasing 100 shares of a $50 stock requires an initial margin of $2,500 plus commissions, or 50 percent of the purchase price plus commissions. The loan made to the buyer would equal $2,500, or the remaining 50 percent of the purchase price.If a margined position loses money, the account equity will decrease both absolutely and as a percentage of the total account value.
Minimum margin is the level, expressed as a percentage of account value, above which account equity must be maintained. If account equity falls below the minimum margin level, the brokerage firm will notify the investor in a margin call that the account equity must be raised to the level of maintenance margin. Maintenance marginis a level of account equity greater than minimum margin and generally below initial margin.
On receiving a margin call, a customer may either deposit additional funds or securities or close the position.In the preceding case, a stock price decline from $50 to $35 would cause a decline in equity to $1,000 because the margin loan of $2,500 remains constant. This $1,000 equity would represent only 28 percent of the account value (1,000 divided by $3,500 0.28). If the minimum margin were 35 percent, the account equity would be under the requirement, and the customer would receive a margin call.
Although many option strategies are marginable, the important point to understand here is that the amount of equity supporting a position is a key element in capital management, and how an investor manages capital is a decisive factor in determining the risk level of a strategy—that is, whether a particular strategy is speculative or conservative in nature. The application of this concept will be developed throughout the coming chapters.