What Is a Liquidation Margin?
Buying securities on margin allows traders to leverage their investments, potentially earning greater returns than from a cash-only purchase. However, this increased potential for profit also comes with higher risks. When the stock price falls, traders might experience losses exceeding their initial investment.
The liquidation margin is the value of all positions in a margin account, which includes cash deposits as well as the market value of open long and short positions. If this margin dips too low, traders might face margin calls and forced liquidation by their brokers.
Key Takeaways
- The liquidation margin reflects the current value of a margin account involving both cash deposits and the market value of open positions.
- Allowing a liquidation margin to fall too low can trigger margin calls from brokers.
- Traders can increase their liquidation margins by depositing cash or other forms of collateral.
Understanding Liquidation Margins
Margin trading involves borrowing money from a broker to execute leveraged transactions, such as buying or selling securities. This practice requires careful management of the account’s liquidation margin, which must remain above a specific threshold. A continuing decline in the stock value can jeopardize this margin.
Consider a scenario where a trader makes several leveraged stock purchases. If these investments incur losses, the liquidation margin will decrease. Persisting losses can invoke a margin call, compelling the trader to provide additional collateral.
A margin call requires the trader to augment their account by adding more collateral—often in the form of cash deposits—thereby elevating the liquidation margin to surpass the required level.
Types of Liquidation Margins
For a trader holding a long position, the liquidation margin equals the value they may retain if the position is closed. Conversely, for a short position, the liquidation margin represents what the trader would owe to repurchase the securities.
Example of a Liquidation Margin
Scenario: Sarah, a margin trader, invests $10,000 in a stock using 100% leverage, equating to a 2:1 leverage ratio. Initially, Sarah holds $20,000 worth of stock. If her stocks decline by 25%, her 2:1 leverage results in a 50% loss to her initial investment, reducing her account’s liquidation margin to $5,000 while holding stock worth $15,000.
If Sarah’s equity falls below brokerage requirements, she will inevitably receive a margin call. To address this, she must deposit additional cash or sell securities. However, delaying the sale post a margin call could lead to a margin liquidation violation.
Such a violation occurs when a margin account faces both Federal Reserve and exchange calls and the trader opts to delay security liquidation instead of complying with the required cash deposit.
Understanding Liquidation
Liquidation is converting assets into cash or liquid assets.
Handling Margin Liquidation
If an investor receives a margin call and cannot provide funds to satisfy it, the broker might be forced to sell holdings until the liquidation margin requirement is fulfilled.
Margin Liquidation Level
The specific level at which the liquidation margin is enforced varies between brokerages and asset types. Higher-risk assets generally have stricter liquidation margins. Investment firms and brokerage websites typically provide detailed explanations and calculation tools for their clients.
Related Terms: leverage, margin loan, forced liquidation.
References
- FINRA. “Margin Regulation”.
- Fidelity Investments. “Avoiding Margin Account Trading Violation”s.
