This means if an investor has established a margin account with a brokerage and wishes to purchase $10,000 worth of a stock, that investor must have a minimum of $5,000 of their own cash in the account–50% of the total purchase.
How Regulation T Works
In determining whether or not to approve a request for a margin account, a brokerage typically reviews an applicant’s income, net worth, estimated liquid net worth, and possibly their credit history. Because margin accounts are essentially a broker-dealer’s agreement to loan money to the account holder, brokerages may establish their own regulations for these accounts with stricter guidelines than the federal regulations.
Freeriding Violations
Although Regulation T is commonly thought of as setting rules for margin accounts, it also establishes transaction rules for cash accounts created by brokerages. For example, it prohibits an investment tactic known as “freeriding,” which essentially is executing a purchase, promising to send funds necessary for the purchase, but then selling the shares and reaping a gain without ever providing the money for the purchase. How would this play out? Say an investor who has $5,000 in a cash brokerage account purchases $10,000 worth of stock with a promise to wire the remaining $5,000 balance within two days. If those shares jump to $15,000 in value the next day and the investor sells, reaping the $5,000 gain while never actually paying the $5,000 that was due at the time of the original purchase, that is a freeriding violation. An investor who commits a freeriding violation is subject to having their account frozen for 90 days. If an account is frozen, the investor may continue to purchase securities only as long as there is sufficient cash in the account to cover the full amount of a purchase.
Cash Liquidation Violations
Similarly, if an investor executes a purchase of shares of a security with no available cash in the account to cover the cost, then a day later sells shares of a different holding to pay for the first order, that is a “cash liquidation” violation. An investor who incurs three cash liquidation violations in a 12-month period in a cash account will have that account restricted for 90 days. This is similar to freezing an account. The account holder will only be able to execute purchases that they have sufficient settled cash to cover the trade.
What It Means for Individual Investors
Investors need to remember that while margin accounts provide opportunities for significant gains, they also pose a higher risk. Investors whose portfolios fall below a certain threshold may be forced to sell shares of stock at a loss due to a margin call. The longer time horizon of investing for retirement can allow for a few bad decisions, but it’s important to be right as much as possible when you are investing with borrowed funds.
