Perhaps the biggest difference between the SIE and the Series 7 (despite the latter being much longer) is that the Series 7 exam has a lot more math on it. You aren’t only supposed to know how, for instance, average cost basis is calculated—you’re supposed to actually do it.
Consider the issue of cost versus price per share in the context of dollar cost averaging. If you are a wealth manager and you have a client who has purchased a mutual fund in four separate transactions, there are two ways to calculate the total cost. Consider the following:
May 1: Spent $1000 on a fund at $50 per share
June 1: Spent $1000 on a fund at $40 per share
July 1: Spent $1000 on a fund at $50 per share
August 1: Spent $1000 on a fund at $40 per share
The price per share to calculate this is not the same as cost per share. The average price per share is done simply by averaging the cost of the shares spent per month, which would be 45 in this case ((50+40+50+40)/4).
For the average cost per share, we need to incorporate the total spent as well, which gives us a different amount of shares per month that influences the average cost:
May: 20 shares bought at $50 each
June: 25 shares bought at $40 each
July: 20 shares bought at $50 each
August: 25 shares bought at $40 each
Now we combine the total shares bought (90) and we can divide the total amount spent ($4,000) on this 90 to get $44.44, the right answer.
Knowing the difference between price per share and cost per share and similar fine mathematical differences is crucial for succeeding in the Series 7. Consider the SMA account calculations.
The special memorandum account (SMA) is employed with margin accounts and is best understood as a revolving credit line dependent upon the value of an account. There are two ways to calculate an SMA—one for long margin accounts (where margin is used to buy assets on margin) and short margin accounts (where margin is used to short stocks).
For long margin accounts, the key is to use the formula LMV – DV = EV, where LMV = long market value, DV = debit value, and EV is equity value. Consider an account for a trader who has bought $20,000 of stock on margin at maximum Reg T leverage, which is of course 50%. Here the numbers are easy:
LMV = 20,000
DV = 10,000
EV = 10,000
Initial calculations for the SMA are easy, but let’s make things a little harder.
Now let’s say there’s an investor who purchases 100 shares of stock at $800 and the stock rises to $1,200. What’s the SMA now?
Let’s start by establishing our values for the first trade:
LMV = 80,000
DV = 40,000
EV = 40,000
Now the stock has risen to $1200, we have:
LMV = 120,000
DV = 40,000
EV = 80,000
Note that the EV has gone up, but the $40k profit we see above isn’t what we are looking for. We need to define the excess equity for margin purposes, and to do that we need to remember that excess equity = equity – 50% of the current LMV. This is important—as the LMV goes up, the proportion of assets to borrowing cannot change. Currently, we have 66.7% equity to LMV, way above the 50% requirement—but since LMV is $120,000, we need to recalibrate our EV accordingly.
In other words, let’s assume the $120,000 needs a 50% maintenance margin, so now the account needs $60,000 of value before it faces a margin call. This means that there is excess equity of $20,000: EV-0.5*LMV = $20,000.
The math isn’t difficult as long as you know what you are doing and what information you need to pull in at the right time—practice can help the student get comfortable with this calculation.
With short margin accounts, the math is a little more confusing even if it isn’t more complicated. In fact, it’s easier. The calculation here is:
SMV + EV = DV
For example, consider an investor who sold short 1000 shares when they were trading for $50 each with a minimum RegT margin account deposit. Now the stock is worth $35 per share.
We want to calculate the SMA for the short account, which also tells us how much more the account can sell. Again, we want the value of the total account ($50k) at the start of the transaction and the DV is easy as it’s half of that, so $25k. It also means our equity is $25k, and thus our DV is $75,000:
50,000 + 25,000 = 75,000
Now keep in mind that the stock has fallen to $35, which means that the SMV has changed to $35,000. Our DV has not changed at all, though, which means our EV has.
35,000 + EV = 75,000
Simple algebra tells us EV is now 40,000, and it also means that our selling power (also our excess equity) is the same (EV – 0.5*SMV), so we now know that our excess equity is now $22,500.
The steps here may feel unnatural at first, and unfortunately the only answer to that is practice. Practicing these kinds of calculations with random numbers can help you get used to the formulas so that, when you take the test, you know them better than the test writer does. And that’s how you can pass the Series 7 and start to work on Wall Street.