Collateral for hypothecated loan is the existing portfolio of eligible stocks and bonds. This includes the stocks and bonds purchased in the margin account.
Know How Margin Accounts Work
Obtain and read the hypothecation agreement. Hypothecation for common stock refers to a broker-dealer lending money to a customer’s margin account.
Lending requires collateral. Bonds can usually be borrowed for up to 80-90 percent of their value if they are of investment grade or US treasury securities. Stocks may be borrowed against for 70 percent of their value. The margin requirements for all stocks and bonds is described under Regulation T of the Federal Reserve Bank rules. Margin requirements rarely change. When stock is hypothecated the collateral stock must be set aside in a special account called the margin account. Options must always reside in margin accounts, more helpful hints.
Risks of Margin Accounts
Cautious borrowers have to understand and be careful of the risks of margin calls. A margin call occurs when the pledged collateral for a margin loan is no longer sufficient to meet a margin of safety. The broker-dealer has no choice but to demand within 2 business an amount sufficient to offset the decline in the value of securities pledged. For example, a broker lends $75,000 to an account and the next day the pledged securities fall by 50 percent. The borrower may have to post additional collateral of as much as $37,500. Profits and losses are exaggerated and move quickly with margin accounts.
You Must Have a Margin Account to Buy Options and Short Stocks
Short a stock or trade options in an account requires hypothecation. Therefore both stock and options must be in the customer’s margin account. Shorting a stock implies borrowing stock in the marketplace. The borrowed stock has property value and thus must be collateralized. Options have a decaying time value and a strike price that implies leverage and greater volatility than a stock. Put option strategies often imply the borrowing and selling of stock not available at the moment. Therefore, hypothecation may be called for and collateral required.
Margin Accounts Are Full Recourse Accounts
Stock purchased on margin or stock shorted in a margin account must pay to borrow the stock that is hypothecated. Brokers charge margin rates depending on the amount borrowed, not on the quality of the customer. The hypothecation agreement is regarded as a promise to pay if the pledged collateral is insufficient. Brokers will look to the individual to make good any margin calls. Margin calls are not non-recourse loans.
Key Points to Remember
Check brokerage rates as there are different thresholds for margin debt at different firms.
Stocks that decline below $5 per share are not eligible for margin. This has important implications for what stocks you may choose to market
Brokers may add their own house rules in addition to required New York Stock Exchange or Federal Reserve Bank rules. Know what is required in the agreement.
Leverage is a double edged sword. Make certain you understand the implications of your trading plan and the effect debt will have.