The Finance Professor: Understanding Leverage

• Cash Account: An account in which all securities are paid for in cash and no extension of credit has been made by the broker-dealer to the customer.
• Margin Account: An account in which securities have or can be pledged to a broker-dealer for a margin loan. Retirement accounts cannot be margined.
• Margin Agreement: A document that spells out the terms under which the extension of credit is made. Furthermore, the client will pledge the securities as collateral under a hypothecation agreement, which creates a lien against the securities in the margin account.

  The hypothecation agreement will also permit the broker-dealer to borrow shares free of charge to secure its own loan (rehypothecation ). Be careful, because buying stock on margin can help feed a short-seller's need to borrow stock and shoot against your investment.

• Margin Securities: These are securities that are eligible for extension of credit under margin agreements in margin accounts. There are regulatory definitions that outline the requirements for a security to be considered margin-eligible. In addition, individual broker-dealers may place even more-stringent requirements upon certain securities above the regulatory minimum.
• Minimum Margin: This represents the minimum amount that a broker-dealer will require a customer to deposit in order to establish a margin account.
• Initial Margin: This is the amount of money that you can borrow for the purchase of a stock. According to Regulation T, this initial amount is 50%. Thus, if you desire to purchase 100 shares of Goldman Sachs (GS - Cramer's Take - Stockpickr) at $200 per share, of the total purchase price of $20,000 the investor can borrow no more than $10,000 (50% of $20,000) at the time of purchase from the lender.
• Margin Loan: Sometimes referred to as a debit balance in a margin account. This is the amount of money the broker-dealer has lent to the individual to purchase margin securities. Margin loans are charged interest at a margin rate as determined by the broker-dealer.
• Equity: This is simply the value of your securities less your outstanding loans or what your account is worth.
• Maintenance Margin: Think of this as an equivalent of the loan-to-value concept for home mortgages. The maintenance margin states the minimum equity that must be maintained in a margin account relative to the market value of the securities. Regulation T requires a 25% maintenance margin while many broker-dealers require higher levels of maintenance margin. Here is how you determine the maintenance sufficiency:

  If market value multiplied by maintenance margin is greater than or equal to market value less margin loan, then you have sufficient equity.

  If market value multiplied by maintenance margin is less than market value less margin loan, then you will be subject to a margin call.

• Margin Call: This is a lender-issued requirement that calls on the borrower to deposit more cash or marginable securities in the margin account to satisfy the maintenance margin. If additional assets cannot be deposited, then securities must be sold. To satisfy the margin call under the margin requiremen, the broker-dealer can liquidate securities without prior investor approval. In the GS example, if the value of GS fell below $13,333, then a margin call would be made, since 25% of $13,333 equals $3,333, which is also equal to $13,333 less the initial loan of $10,000.