Investing Answers Building and Protecting Your Wealth through Education Publisher of The Next Banks That Could Fail
Investing Answers Building and Protecting Your Wealth through Education Publisher of The Next Banks That Could Fail

Same-Day Substitution

What it is:

Same-day substitution is the act of withdrawing money from and adding money to a margin account on the same day.
 

How it works (Example):

Let's assume you want to buy 500 shares of Company XYZ for $5 per share and 500 shares of Company ABC for $5 per share but don't have the $5,000 necessary to do so -- you only have $2,500. If you buy the shares on margin, you essentially borrow the other half of the money from the brokerage firm and collateralize the loan with the shares. This original loan amount as a percentage of the investment amount is the initial margin.

If the value of the shares drops past a certain point, say 25% of the original $5 value (or $1.25 per share; this point is called the maintenance margin), the brokerage firm may make a margin call, meaning that within a few days you must deposit more cash or sell some of the shares to offset all or part of the difference between the actual stock price and the maintenance margin.

However, if the value of Company XYZ falls but the value of Company ABC increases by the same amount, the same-say substitution effect means that the account balance stays the same and you avoid getting a margin call.

Why it Matters:

Margin accounts allow investors to make investments with their brokers' money. A margin call is a brokerage firm's demand that a margin-account client make up the difference between a security's price and a minimum maintenance margin.

Margin accounts can magnify gains, but they can also magnify losses. Getting a margin call means that not only do you have to pay back the original $2,500 of principal eventually, but you have to pay the margin call. In some cases, a brokerage firm can sell an investor's securities without notification or even sue if the investor does not fulfill a margin call. However, if the stock rises from $5 to, say, $15, you've just made $10,000 without investing all of your own money. For these reasons, margin accounts are generally for more sophisticated investors who understand and can handle the risks involved.