Course: Investment Planning
Lesson 3: Equity Securities
I’m having trouble following the math on the example (shown below) at the bottom of the page. Could you please walk through the calculations? I understand how the initial margin with cash amount is calculated, but it gets a bit fuzzy for me after that.
Jarrod would like to purchase 100 shares of XYZ on margin at $200 per share. He goes to Sorrow Brokerage House and is told that they will require a 60% initial margin call. The settlement date on the transaction is T+2.
For Jarrod to be able to purchase the 100 shares at $20,000, he will have to put $12,000 of cash into his margin account at Sorrow within 2 days of the transaction.
If Jarrod chooses to collateralize with securities instead of cash, for every thousand dollars worth of securities placed in the account, he could gain credit of $400. Thus, he would need to pledge $50,000 of securities to have sufficient collateral to purchase the $20,000 shares on margin.
Minimum Maintenance Requirement
For Jarrod to remain in good standing, he would need to keep his account at 25% equity after the initial margin. So let’s assume the value of Jarrod’s shares declined to $16,000. That would mean he had lost $4,000. He now has $8,000 in equity, or 50% of the total value, which is well above the minimum maintenance requirement.
For Jarrod to receive a margin call, the total value of equity would need to fall to 25%. That would happen if the total value of the account fell to about $10,650. At that point, if Jarrod had not put any additional cash into the account at any time, he would have $2,650 in equity, which would be 24.9%. At that time, Jarrod would receive a margin call and need to deposit more cash into the account.
Happy to help here.
Here, we are looking to have no less than 25% equity in our position. Think about it like a home. If a home is valued at $400,000 and you put $100,000 in cash down, then you have 25% equity. That remaining $300,000 would be a mortgage. So, 25% equity and 75% debt (what you owe). Now if the house increased in value to $500,000, you would still have your $300,000 of debt and your equity position grows to $200,00, or 40%. However, if the market crashes and your home is now worth $300,000, then you are 100% debt because you have the $300,000 mortgage to pay and only have a home worth that same amount.
Same thing with a brokerage account. In our example, he started with $12,000 in cash and $20,000 worth of stocks. This would mean he has $8,000 he “owes” the brokerage account. So, he has 60% equity and 40% debt. But he’s fine at this point because if he had to, he could sell all of his stock and get his $12,000 back and pay the brokerage the $8,000 he owes them. Now, if his stocks lose value down to $16,000, he would still have the $8,000 in debt, which means he only has $8,000 in equity. So, he’s at 50% equity and 50% debt.
A margin call takes place when equity position drops to below 25%. Or another way to look it, when debt grows to 75%. So, how do we know when Jarrod hits that? We know he owes $8,000 to the brokerage, so $8,000 is 75% of what? To calculate that, we do $8,000 divided by .75. That equals (about) $10,650. If the value of his account drops all the way down to $10,650, that would mean he has $8,000 in debt (75%) and $2,650 in equity (25%).
Does that help to clarify, Robert? Let me know.