Within the stock market, multiple types of accounts exist. Each of these is designed for a distinct purpose and governed by a unique set of rules and regulations. A special memorandum account or an SMA is one such account. It is essentially a line of credit where the extra equity of margin accounts is deposited, thus increasing your capacity as an investor to purchase stocks on margin.
In this article, we will understand what a special memorandum account is, how it functions, and its significance.
Additional read: Trading on equity
What is a special memorandum account and how does it work?
As mentioned earlier, a special memorandum account is a line of credit where the additional margins from your individual margin accounts are deposited. Owned by a broker, an SMA operates much like a credit account. It has two functioning signals—a positive SMA and a negative SMA. Having a negative SMA is always a cause for concern. Therefore, you should be vigilant at all times to evade a negative SMA. In case you end up with one, you should be aware of its possible repercussions beforehand to establish any contingency strategies.
Every deposit that is made to an SMA results in a corresponding increase in the worth of stocks or derivatives. Likewise, credits are in line in an SMA whenever a percentage of your income, such as dividends, is deposited. You are qualified to withdraw credits from your SMA that could be used to buy more shares. Maintaining a positive SMA value is imperative, especially if you plan to keep investing in new stocks.
Additional read: Equity share capital
Why is it crucial to keep an eye on a special memorandum account?
When the value of an SMA slips into a negative territory, the broker will issue a margin call for all traders. Simply put, a margin call is when the broker requests you to add more funds or assets to offset the losses and meet the margin prerequisites. To satisfy this margin requirement, you will have to sell some of your securities, which is seen as an undesirable solution in financial investing. Moreover, you need to have a positive SMA balance to afford new stock purchases.
Here is an example explaining the inner workings of an SMA. Assume you want to invest in a stock, and its margin requirement is Rs. 10,000. You will need this specific amount in your account to execute the trade. If you do not have this amount in your SMA, you won’t be able to enter any trades until you manage to add more money or until the value of what is already in the account increases.
What is the purpose of a special memorandum account?
An SMA increases the buying power of your margin or brokerage account. It secures all the gains realised in the margin account.
Additional read: Debt-to-equity ratio
What are some considerations to make before opening a special memorandum account?
You must be mindful of the following factors while opening an SMA:
- The SMA is maintained alongside a margin account.
- The value of the assets in a margin account keeps fluctuating regularly.
- Additional equity occurs when an account has more equity than prescribed, i.e., exceeding 50%.
- When the computation hints at extra equity, a broker can automatically transfer the excess from a margin account to an SMA.
- The broker considers a single entry amount to be a debit transaction in the margin account while computing its equity.
- The SMA’s value increases when the security’s value rises, but it does not decrease when the security’s value declines.
- Upon the transfer from a margin account to an SMA, the diminished value of the assets in a margin account does not influence the transferred amount.
- The margin account and SMA can be debited and credited with the same amount. These two accounts can be affected by a simple increase or decrease of an entry.
- Payments made by the broker to you as an investor or on your behalf and the transfers made via the SMA to your other accounts can reduce a single entry’s amount.
The special memorandum account includes the following entries:
- Payments of interest and dividends only.
- Cash deposited to fulfil a maintenance margin call or any other requirement enforced by a self-regulatory body.
- Any lapsed or liquidated positions suitable for withdrawals under the margin account that do not mandate the selling proceeds of any securities or cash.
Closing thoughts
A special memorandum account is a distinctive account that enables you to increase your buying power. Primarily, this account represents the excess margin generated in a transaction. While SMAs offer you a higher level of control over your investments, it is important to evaluate the rewards and risks involved before you open such an account.
