Series 7 Study Guide Navigation
- Series 7 Study Guide Home
- 1.1 Contact with potential and current customers, marketing material development, approval, and distribution
- 1.2 Describing investment products to potential and current customers
- 2.1 Tells potential customers about the account types available and discloses their restrictions
- 2.2 Secures and updates information about customers along with relevant information and documents
- 2.3 Gather customer investment profile information
- 2.4 Get necessary supervisory approval to open accounts and make account changes
- 3.1 Passing on all investment strategy information to customers
- 3.2 Analyze customer’s portfolio of investments as well as product options to determine suitability
- 3.3 Disclose to clients characteristics and risks of investment products
- 3.4 Communications with customers
- 4.1 Providing current quotes for investors
- 4.2 Processing and confirming customers’ transactions as per regulations
- 4.3 Notifies the correct supervisor, helps with solving discrepancies, disputes, errors, and all complaints
- 4.4 Dealing with margin issues
Margin accounts are regulated by the Federal Reserve Board and as we know, they allow investors to pledge securities as collateral.
This means they are able to borrow money through brokerage firms.
When investors have margin accounts with member firms, it’s expected that they will market to market positions daily.
This helps to ensure that the minimum requirements for account equity are met each day.
Types of margin accounts
Margin accounts are broken down into two types and these are long and short accounts.
- Long margin account: Here securities are purchased with borrowed money and until the loan is paid up, interest will be paid on the amount borrowed
- Short margin account: Member firms short the stock they have borrowed. If the value then declines, the customer will make a profit.
So basically, it works like this:
- Long margin accounts: Money is borrowed by customers
- Short margin accounts: Securities are borrowed by customers
There are two main advantages to margin accounts.
Firstly, more securities can be bought. Also, the initial cash outlay to do this is much lower.
Secondly, the investment can be leveraged. This is because a portion of the purchase price can be borrowed.
Note that the rate of return (or loss in poor market conditions) is amplified by leveraging.
For broker-dealers, margin accounts too, hold some advantages.
The most significant perhaps is that they offer a form of revenue for the firm thanks to the income interest they generate.
They also create higher commissions.
That’s as a result of margin customers having increased trading capital which means they trade larger positions.
Margin account agreements
Before any trading is allowed on a margin account, a customer who has opened one must first sign a margin agreement.
There are three parts to this:
- A credit agreement
- A hypothecation agreement
- A loan consent form
Let’s look at the credit agreement and exactly what this entails.
Well, as with most agreements like this, it contains the broker-dealer’s credit terms that they extend to the customer.
Information found in the credit agreement includes how interest will be calculated, as well as the events that might lead to a change in interest rates.
What’s the hypothecation agreement entail then?
This gives the go-ahead that customer margin securities can be used as collateral by the broker-dealer.
The process for this is as follows.
Customer securities are offered as collateral to a bank and based on their value, money is loaned to the broker-dealer.
These securities will be registered in the name of the firm, which is known as being held in street name.
The member firm is then said to be the named or nominal owner.
They don’t have rights of ownership, however as that remains with the customer, also known as the beneficial owner.
This process in which the banks lend money to a member firm based on a customer’s security used as collateral falls under Regulation U.
Note that when it comes to a customer’s debit balance being pledged as collateral, member firms are limited to 140% of that balance.
Those securities that are over this amount will need to be separated and commingling securities owned by the member firm and those owned by the customer is not allowed.
That doesn’t rule out commingling between the same type of securities that are owned by two different customers.
Of course, their permission to do this will have to be secured beforehand.
Loan consent form
The last part of a margin account agreement is the loan consent form.
When an investor signs this, the member firm has permission to use a customer’s securities for short sales.
They can do this by lending them out to other broker-dealers or even other customers.
While the loan consent form is optional for the customer to sign, they must sign both the hypothecation and credit agreement.
Just an example tip regarding margin customers and the interest that they will pay on money that they borrow.
This will always be based on the broker call rate and it is a variable rate.
Margin risk disclosure
Should an investor approach a member firm to open a margin account, before that happens, or when it happens, they must be giving a margin disclosure statement.
That’s not the only time this will happen, however.
All customers of a member firm that have a margin account must receive this document every annum.
You can probably guess what the document includes, right?
Yes, it covers all the risks that an investor can expect to come across when trading with a margin account.
Here are some of those risks that will appear in the document:
- Losses can go past the amount that was initially deposited by the customer
- When the call for additional funds occurs, customers may not select the assets or securities that will be sold or liquidated to achieve that
- Margin calls must be met at the time indicated and extensions will not be given
- Without any advance notice, member firms can raise their own in-house margin stipulations
Regulation T and margin securities
In the securities industry, the Federal Reserve Board has the power to regulate how credit is extended as per the Securities Exchange Act (1934).
Regulation T, therefore, says that within two added days of a regular way settlement (for most securities, this is T+2), customers will need to deposit at least 50% of the transaction’s price.
From time to time, this is referred to as an S+2 or a settlement plus 2.
Within four business days of the transaction, the deposit must be paid.
Regulation T is not only for margin accounts but cash accounts as well.
Required payments must happen within two business days of the settlement.
Regulation T has another purpose, however, which relates to marginable securities.
This means that it can help show which securities can be purchased on a margin as well as those that could be used as loan collateral to fund other purchases.
The latter is known as marginable securities.
Here’s a breakdown of which securities can be used as collateral when purchased on margin:
- Bonds, stocks that are exchange listed
- Stocks found on the Nasdaq index
- Federal Reserve Board approved non-Nasdaq OTC issues
What about securities that cannot be used as collateral or cannot be purchased on margin?
- Put options
- Call options
- Non-Nasdaq OTC issues that aren’t Federal Reserve Board approved
- Insurance contracts
Finally, here are the securities that can be used as collateral after 30 days but cannot be bought on margin:
- Mutual funds
- New issues
Deadlines for meeting margin calls
We’ve already seen that with Regulation T, margin deposit requirements for customers must happen within two business days once the settlement date is known.
Deposits can be made in two ways:
- Marginable securities with a value of 200% more than the Regulation T cash call
Broker-dealers are allowed to apply a DEA or designated examining authority if late payment should occur.
By doing so, they can gain an extension.
Either FINRA or an exchange can be the broker-dealer’s DEA.
From time to time, the Federal Reserve might even act in that capacity.
By the morning of the third business day following the settlement, if no extension has been granted, the account is frozen for 90 days.
The member firm will also be required to sell out the securities that were purchased.
A full payment will need to be made in the account if the customer wants to purchase further securities while the account is frozen.
This payment must take place before order entry.
When securities are bought and then sold without a purchase payment on the settlement date, it’s known as freeriding.
For the most part, this isn’t something that is allowed on margin or cash accounts.
Should it occur, the customer’s account will also receive a 90-day freeze order with no transactions allowed unless they can be either covered by marginable securities or cash.
Either of these must be present in the account before the purchase is carried through.
Here’s an example of freeriding.
Let’s say a customer purchases 10 shares of XYZ at a price of 20 on a Tuesday.
The next day (Wednesday), they sell the shares at 22.
The trade must be settled by Thursday (using the T+2 concept) but instead, the broker-dealer is instructed to use the money coming in from the sale on Friday to settle up with the profit made, 20 staying in their account.
Because the purchases were not paid for by the time the sale took place, the customer account will be frozen.
When day traders buy and sell on the same day, why are their accounts not frozen then?
Well, a frozen account is avoided in this case because:
- Before making any trades, they make sure that they have enough money in their accounts
- They use “swap” checks on the settlement date. This means the broker-dealer is paid and following that, payment for the sale is received.
Regulation T requirements don’t affect all securities.
Let’s look at some of those exempt securities that aren’t affected by it.
For some securities, the determination of an initial requirement as per the member firm is what they will be subjected to although FINRA maintenance requirements, as well as the SRO rules that govern them, will come into play.
For the exam, knowing the types of securities that are exempt from Regulation T is enough.
And they are:
- U.S. Treasury bills
- Municipal securities
- Government agency issues
Initial requirements for margin accounts
There are some requirements that are put in place before a client is allowed to open a margin account.
To start, before the first purchase can be made from the account, a minimum amount of equity must be deposited by the customer.
This initial deposit must be $2,000 or more as stated in FINRA regulations or unless paid in full.
Regulation T, however, says that the deposit should be 50% of the market value of the securities purchased.
Therefore, the greater of the requirements as stated by Regulation T or the FINRA minimum is the deposit.
Should the initial purchase be lower than $2,000, however, a deposit FINRA-minimum deposit of $2,000 will not be required.
The only amount that needs to be in the account to facilitate that purchase is the full price that the securities will cost.
Here’s an even easier way to remember it:
- First purchase by a customer lower than $2,000 means that the full purchase price must be deposited
- First purchase by a customer between $2,000 and $4,000, $2,000 must be deposited
- First purchase is over $4,000, 50% of that purchase price must be deposited
When it comes to short margin accounts, FINRA minimum rule ($2,000) is always in play.
Note that at no point will this be set aside on accounts like this.
Active margin accounts must always be checked when market value fluctuates, specifically in terms of whether they still meet minimum requirements.
When recalculation takes place to check the equity in the margin account, it’s called marking the market.
Based on the closing price of the stock, this should be carried out every single trading day for both short and long margin accounts.
Long margin accounting
You’ll come across the following terms in the exam that represent long margin account activity.
- LMV or long market value: This relates to the stock position an investor purchased and the current market value thereof
- DR or debt register: This relates to the money borrowed by the customer reflected as a dollar amount
- EQ or equity: This shows the fully owned portion of securities for a customer. It’s their net worth in the margin account.
The following equation is used to determine the amount of equity in an account: EQ = LMV – DR.
When dealing with long margin accounts, we’ve found that it helps to see them as similar to a house with a mortgage.
While the mortgage amount won’t change should the market value of the house rise or fall, the equity will.
That’s the same with a margin account.
In other words, what the customer lowest to the broker-dealer, their debit balance on their account, will stay the same if the security goes up while the equity will increase at the same time.
The opposite is true when the securities go down.
The debit balance will stay the same but the equity will lower as well.
But what about when money is paid into a margin account?
Well, that will affect the debit balance, or the money owed by the customer.
It has another effect as well and that’s the fact that the overall equity will increase as well.
When it comes to long margin account activity, to analyze it, use the following:
- LMV is considered an asset
- DR is considered a liability
- EQ is the difference between these two amounts
Remember, it’s critical that broker-dealers ensure there is enough equity in a margin account at all times, especially when the market value of securities change.
This is achieved by mark to market of the positions which helps identify the overall status of the customer account.
The minimum maintenance requirement on a long margin account as per FINRA requirements is a quarter (25%) of the LMV.
To work out the customer account status, two benchmarks will need to be worked out:
- Regulations T (this is measured at 50% of the LMV)
- Minimum maintenance (this is measured at 25% of the LMV)
When carrying out long margin accounting, consider this helpful advice:
- DR will not change no matter if the market value of a security rise or falls
- When calculating minimum maintenance and Regulation T when marketing to the market, it’s based on the new LMV.
When is an account considered to be restricted?
Well, it’s simple and something we’ve mentioned a few times already.
An account is restricted as soon as its equity is lower than the requirement as set out by Regulation T.
The following rules will apply to accounts that are restricted:
- 50% must be made available if additional securities are to be purchased
- A cash deposit of equal to 50% of the value of the securities to be taken out of the account is necessary if any withdrawal is to take place
- In an effort to reduce debt balance, any securities sold in a restricted account will see half the proceeds of the sale kept in the account in what is commonly known as a retention requirement. SMA will be credited with 50% of the proceeds as well.
Let’s just expand on SMA a little.
This is like when a bank extends a line of credit to a customer and it preserves the right of the customer to make use of excess equity.
We will discuss that concept a little later on.
Let’s talk about the minimum maintenance requirement and what exactly happens should the account fall below this?
Well, the first thing that happens is that a maintenance margin call will be sent to the account owner.
This is a request, well more of a demand actually, and it asks the account owner to make a payment into the account.
This payment must be enough so that the account will once again move above the minimum maintenance requirement.
Should this payment not occur, the broker-dealer will then liquidate securities that are in the account to bring the balance back to the minimum requirement.
The account owner has two ways in which they can comply with the margin maintenance call:
- They can either meet the minimum account balance by depositing cash into their account
- They can fix the balance by using fully paid marginable securities
It’s important to note that many broker-dealers don’t use the FINRA minimum maintenance level on their customer margin accounts.
Instead, they use higher levels, often up to 35%.
This is commonly called the house minimum.
For the Series 7 exam, it’s critical to remember that Regulation T does not cover any requirements that relate to a customer account’s margin level that must be maintained following the buying or short selling of securities.
Maintenance equity rules that are enforced come from SROs only.
The SMA and excess equity
What is excess equity?
Well, when looking at a margin account, this would be based on the amount of equity in it, specifically, that which goes beyond that which surpasses the requirements as set out by Regulation T.
As a way of determining the SMA or buying power, you can use the following rule:
- When the market value of a security increases by $1, $0.50 of the SMA is formed.
We’ve mentioned above that SMA is the buying power within a margin account.
It’s created through excess equity.
SMA provides a credit line for a customer.
They can use it in two ways:
- Either to purchase securities
- Or they can borrow from it
So because of a margin account’s increased equity, SMA is created.
Effectively, it added an extra line of credit for a customer to use.
The customer account debit balance will increase and the equity will drop when the SMA line of credit is tapped into.
Also note that when working out the SMA amount as per Regulation T, it is equal to either the excess equity in the account or the SMA already found there, whichever is greater.
It’s worth also noting that when compared to the excess equity, SMA may often be more than that.
This can be the case too even if the account has no excess equity in it.
In some situations, SMA may not be used by customers, even if it is never lowered when the value of the market drops.
For example, while it’s available for use, even in restricted accounts, if it is going to bring the account below the minimum maintenance level, then the customer may not use the SMA option.
So while we have covered the fact that an increase in excess equity as a result of market value going up will bring an increase in SMA too, there are other ways to generate it as well.
- The use of nonrequired cash deposits. When cash deposits are put into an account by a customer and there weren’t necessary to meet a margin call, the amount deposited will both lower the debit amount on the account as well as crediting SMA.
- Payment of dividends. When a customer receives dividends paid into their margin account for securities that they own, it gets added to SMA as well. Should the account be restricted, the customer can still withdraw their income distributions.
- Loan value: A stock’s loan value will be credited to SMA should a customer make a nonrequired deposit of marginable stock.
- The selling of stock. If a customer chooses to sell stock that they own, half of the proceeds of that sale will be credited to SMA.
Note, however, that if a customer plans on taking out any cash dividends they receive in their margin accounts, it has to be done within 30 days from the date on which they were received.
If not, the dividend is then put against the overall debt balance which will raise the account’s equity.
So how is SMA used?
Well, we already have established that it’s a line of credit.
There are two major ways that a customer can opt to use SMA.
- They can either use it to withdraw cash
- Or they can use it as a way to meet margin requirements for stock purchases
Also, remember, that even if an account is restricted, SMA can be used.
Of course, any account that has excess equity too can make use of SMA.
Let’s review the critical aspects of long margin account concepts that may appear on the exam:
- When the first transaction on a margin account takes place, it must include a deposit that is more than 50% of the LMV or $2,000.
- If 100% of the transaction is less than $2,000 and is a full payment, the $2,000 minimum is not enforced.
- The margin equation you need to know is: EQ = LMV – DR
- For Regulation T, it always equals 50% of the LMV
- For minimum account maintenance, SRO rules state that the figure must be 25% of the LMV
- Customers can borrow SMA from their account on a dollar-for-dollar basis
- Debit balance will increase when SMA is utilized
- SMA’s buying power is a ratio of 2:1
- SMA and EE are not always necessarily equal
- When it comes to meeting a maintenance margin call, using SMA is not an option
- Regulation T is not applied to some exempt securities. They are still subjected to FINRA maintenance requirements, however.
Here’s a handy breakdown of how various actions will influence SMA.
- When the market rises, SMA will increase but only when the new excess equity level is about that of the level the SMA was
- When there is a sale of securities, SMA will increase. The customer can claim whichever is greater than 50% of the proceeds of the sale or the excess equity left in the account following the sale
- When cash is deposited into the account, SMA will increase as the full deposit amount is credited to it
- When marginable securities are deposited, SMA will increase as per the loan value of those securities as stipulated at the time the deposit takes place by Regulation T
- If dividends or interest is paid, SMA will increase. 100% of either of these goes to the SMA
- If securities are bought, SMA will decrease. New purchases will result in the margin requirement being taken off the SMA. Should the SMA not be enough to meet this, the balance will be requested through a Regulation T call
- If cash is withdrawn, SMA will decrease. Whatever the amount of cash that is withdrawn, this total is taken off the SMA. The equity remaining in the account isn’t allowed to go lower than either house equity requirements or FINRA rules
- If there is a fall in long account market value, there is no effect on SMA
- If there is interest charges on a customer account, there is no effect on SMA
- If there is a stock dividend or split, there is no effect on SMA
Pattern day traders
We all know what a day trader is, right?
It’s someone that looks to buy a security and then sell them on the same day.
Ultimately, what day traders try to do is use intraday price movements to make profits.
When someone carries out four or more day trades across a five-business-day period, they are known as a pattern day trader.
When it comes to the equity requirements for someone who is a pattern day trader, the number is set at $25,000.
That must be on deposit in their account on any day on which they opt, while 2% is the minimum maintenance margin requirement, which isn’t any different from a regular investor.
In terms of buying power, it’s different for pattern day traders as well.
That’s because it is four times the maintenance margin excess for them.
Just a reminder that the equity in a customer account above the minimum requirement of 25% is defined as maintenance margin excess.
When you compare it to a regular customer, well, their buying power is only two times SMA.
Day trading accounts cannot use account guarantees either as per margin rules for these types of accounts.
Day trading account approval.
When a member firm promotes day trading, they have to have various procedures in place so that anyone who wants to get an account like this, gets approval first.
For example, before a day trading account can be opened for a customer, the member firm must:
- Produce risk disclosure documents regarding day trading and ensure that the customer is provided with it. This can be done either electronically or in writing as long as the customer is given all the potential risks associated with day trading.
- Give approval for that account to partake in day trading activities. If the customer does not intend to take part in day trading, they must provide a written statement confirming as much to the member firm.
Short sale and margin requirements
If short sales are to be made, they have to be carried out in a short margin account.
Three parties are in play when a short sale is made: the short seller, a stock lender (where shares are borrowed from), and the buyer.
When it comes to short sales, there is one requirement.
On the payment date for dividends, the short seller has to make good for those dividends.
But what dividends are these?
Well, they are the ones that the issuer is no longer paying to the lender.
Instead, the dividends are received straight from the issuer by the buyer of the shares.
So when the dividend payment date comes along, the account of the seller will be debited.
The amount taken off is a remittance to the stock lender and is equal to the cash dividend.
Let’s look at margin deposits.
Margin deposits are carried out by investors when they want to borrow shares for short sales.
According to Regulation T when it comes to short sales, either marginable securities or cash can be used to meet the initial margin.
This is just how it is with long margin transactions.
The account of a short seller must always have buying power (usually in the form of cash or securities) at all times.
This is because the borrowed shares used must be replaced.
Should the customer be unable to do so, that buying power will allow the broker-dealer to buy the necessary shares.
Here are some terms you may come across regarding activity in short margin accounts in the Series 7 exam:
- Short market value or SMV: The stock position’s current market value when it’s sold short by an investor
- Credit register or CR: This is how much money a customer has in their account. It’s equal to the sale proceeds with the addition of the margin deposit requirement. In theory, it’s like the account’s credit balance.
- Equity (EQ): The net worth of the customer’s margin account. EQ = CR-SMV
Analyzing short margin account activity
Well, to start it’s important that all short margin accounts require that a deposit of $2,000 be made first up.
That’s the minimum.
Should a customer sell short and it’s lower than $2,000 worth of securities, the minimum will remain at this level.
Also, 50% is a percentage that you need to bear in mind as well.
This is a short sale regulation T requirement and you’ll notice that it is the same as for long purchases as we learned earlier.
As for minimum maintenance on short positions based on FINRA requirements, that is set at 30% which is 5% higher when compared to the long positions (25%).
Note that firms are also allowed to impose their own house minimum, which often is higher than the 30% set out by FINRA.
Math for short margin accounts
When dealing with short margin accounts, it’s important to remember the following:
- When securities are sold, their market value is entered as the SMV
- 50% of the SMV (a requirement of Regulation T) is entered as equity
- To work out the credit balance (CR), you take the proceeds of the stock sale (SMV) and you add the equity deposited (EQ).
When it comes to the credit balance, this is a yardstick for the broker-dealer.
It shows whether they have enough in their account to be able to buy securities should those securities’ market value increase.
When it comes to short accounts, the major risk is when there is an increase in stock price.
The only way that a short seller is going to make any money is not when stock prices increase but instead when they fall.
Just a quick reminder, for Series 7 exam purposes.
To get a credit balance, you need to add SMV and EQ together as we’ve covered above.
When the market value changes, you can use this to work out the new equity figure with this equation: Equity (EQ) = SMV – CR.
Like long positions, short positions too, are marked to market every day.
This is so that any change in position value can easily be reflected.
Just as we did with long accounts, let’s change our focus to minimum maintenance on short accounts.
Well, start, the margin when it comes to maintenance on these accounts is set at 30%.
But exceptions can occur when based on price per share:
- The greater of either 100% of SMV or $2.50 per share must be maintained by a short account customer for any stock that trades at lower than $5 per share
- The greater of either 30% of the short market value or $5 per share is the minimum requirement for stock trading at $5 or more. Note that the requirement will only be 30% in this case if the SMV is higher than $16.67.
Combined margin accounts
When a customer holds long and short positions on different securities, they are said to have a combined account.
To determine equity and margin requirements on these accounts, the long and short positions must first be calculated on their own.
Once you have both the long and the short position, they need to be combined to find the equity and margin requirements.
The basic equation to do this is as follows:
- EQ = LMV + CR – DR – SMV
Options and margins
Options are not marginable securities.
Well, there is one that is considered to be and that’s LEAPS.
So if a customer is wanting to purchase an option then before they do so, 100% of the premium of that option will need to be deposited into their account.
Note that a call option does not include any Regulation T requirements if the stock is bought on margin and a covered call is written.
Instead, the customer must be able to cover 50% of the price of purchase and have that amount in their account.
In the case of customers who want to purchase a stock as well as an option at the same time, they will need to have 100% of the premium as well as 50% of the stock’s purchase price in their account to do so.
When LEAPs options have longer than nine months till the point they will expire, they are considered to be marginable.
Also, with options spreads, Customers must deposit the maximum loss as per Regulation T requirements.
That’s different from debit spreads.
Here the maximum loss is represented by the net debit.
For credit spreads, to determine the maximum loss, you will need to take the net credit from the difference between the strike prices.
Customer portfolio margining (CPM)
There are other ways in which to calculate an account’s margin requirements.
One of those ways is through customer portfolio margining.
Instead of looking at each individual position and having a standardized percentage applied to them, CPM calculates margin requirements using the entire portfolio’s net risk.
Compared to when margins are calculated in a conventional manner, this other method generally will generate margin requirements that are lower.
When broker-dealers want to offer portfolio margining to their customers, there are a few requirements that will need to be met:
- To engage in uncovered short option transactions, a customer must be approved first by the broker-dealer
- Based on the capabilities of the broker-dealer, accounts held by customers will need $100,000 or more minimum equity
- REITs are allowed to be included, even those that are listed on the NYSE