Understanding Margin Calls
A margin call occurs when the percentage of an investor’s equity in a margin account falls below the broker’s required amount. A margin account contains securities bought with a blend of the investor’s own money and funds borrowed from the broker.
A margin call specifically refers to the broker’s demand for the investor to deposit additional money or securities into the account so that the value of the investor’s equity rises to meet the minimum value indicated by the maintenance requirement.
When a margin call happens, it usually indicates that the securities held in the account have decreased in value. At this point, the investor must either deposit additional funds or securities or decide to sell some of the assets held in their account.
Key Takeaways
- A margin call occurs when a margin account runs low on funds due to a losing trade.
- It is a demand for additional capital or securities to bring the account up to the maintenance requirement.
- Brokers may force asset sales to meet the margin call if necessary.
- Margin calls can also happen with rising stock prices causing mounting losses in accounts that have sold the stock short.
- Investors can avoid margin calls by monitoring their equity levels and maintaining account values above the required thresholds.
What Triggers a Margin Call?
When an investor buys and sells securities using a combination of their own funds and borrowed money, they are buying on margin. The equity is the market value of the securities minus the borrowed amount.
A margin call gets triggered when the equity, as a percentage of the total market value, falls below a specified level known as the maintenance margin.
Regulatory bodies such as the New York Stock Exchange (NYSE) and the Financial Industry Regulatory Authority (FINRA) require that investors maintain an equity level of 25% of the total securities’ value when buying on margin. However, some brokers may have higher requirements, sometimes up to 40%.
Margin calls can happen anytime due to market volatility, but they are more likely during turbulent market periods.
Real-Life Example of a Margin Call
Below is an example showing how a decrease in the value of a margin account triggers a margin call.
| Description | Security Value | Loan Amount | Equity ($) | Equity (%) |
|---|---|---|---|---|
| Security bought for $20,000 (half on margin) | $20,000 | $10,000 | $10,000 | 50% |
| Value drops to $14,000 | $14,000 | $10,000 | $4,000 | 28% |
| Maintenance requirement of broker (30%) | $14,000 | - | $4,200 | 30% |
| Resulting margin call | - | - | $200 | - |
How to Cover a Margin Call
If a margin call is issued, the investor has a few days to meet the demand. Options include:
- Deposit $200 cash into the account.
- Deposit $285 of marginable securities. This amount comes from dividing $200 by the complementary percentage: $200 / (1 - 0.30) = $285.
- Combine the above two methods.
- Sell other securities to raise the required cash.
If the investor cannot meet the margin call, the broker may sell any open positions to bring the account to its required value and charge a commission on the transactions. The investor bears responsibility for any losses incurred during the process.
How to Avoid a Margin Call
Ensure that having a margin account is essential before opening one, as most long-term investors may not need one. Margin loans come with interest charges, making them costly if not managed correctly.
Here are some strategies to avoid margin calls:
- Keep readily available cash in an interest-earning account at the brokerage.
- Build a well-diversified portfolio to minimize the risk of a single asset affecting the account’s value.
- Monitor open positions and margin levels regularly.
- Set a custom alert to warn you if the account equity approaches the maintenance threshold.
- Act promptly if you receive a margin call.
Using stop orders to limit losses in equity positions can also reduce the probability of a margin call.
Risks of Trading Stocks on Margin
Trading stocks on margin involves higher risk since you’re leveraging borrowed money. The primary concern is that investors can lose more than their initial investment.
Meeting Margin Calls
To meet a margin call, a trader must either pay in cash, deposit marginable securities, or liquidate existing positions to cover the shortfall. This action must be taken immediately to avoid forced liquidation by the broker.
Managing Risks Associated with Margin Trading
To manage the risks of trading on margin, consider:
- Using stop loss orders to limit potential losses.
- Maintaining leverage at manageable levels.
- Borrowing against a diversified portfolio to decrease the chance of a margin call.
Impact of Margin Debt on Market Volatility
High levels of margin debt can aggravate market volatility. In extreme downturns, forced selling to cover margin calls can create a negative feedback loop, escalating stock price declines and increasing volatility.
Conclusion
Buying on margin is not suitable for every investor. While it can enhance returns, it also has significant downsides, including the potential for severe losses and frequent margin calls. Prudent management and understanding of the risks involved are crucial for those considering margin trading.
Related Terms: margin account, equity, maintenance requirement, market value, stock market.
References
- U.S. Securities and Exchange Commission. “Investor Bulletin: Understanding Margin Accounts”.
- Financial Industry Regulatory Authority. “Margin Account Requirements”.
- U.S. Securities and Exchange Commission. “NYSE Rulemaking: Notice of Filing of Proposed Rule Change to Amend NYSE Rule 431 (Margin Requirements)”.
- U.S. Securities and Exchange Commission. “Margin: Borrowing Money to Pay for Stocks”.
