In the world of investing and trading, using borrowed money to increase potential profits is a common strategy. This approach, known as trading on margin, can offer significant rewards but also comes with considerable risks. One of the most critical risks associated with margin trading is receiving a margin call. Understanding what a margin call is, why it happens, and how to respond is essential for anyone involved in leveraged investing.
What Is a Margin Call?
A margin call occurs when a broker demands that an investor deposit additional funds or securities into their margin account to bring it up to the minimum required level. This typically happens when the value of the securities in the margin account falls below a specified maintenance margin requirement.
In simpler terms, a margin call is a warning that your account no longer has enough equity to support your current positions. If you fail to meet the margin call promptly, the broker may liquidate some or all of your assets to cover the shortfall.
How Margin Trading Works
To understand a margin call, it’s important to first understand margin trading. When investors open a margin account, they are allowed to borrow money from their brokerage to buy more securities than they could with just their own cash. This increases their potential return but also amplifies losses.
Key Terms in Margin Trading
- Initial Margin: The percentage of the purchase price that the investor must deposit using their own funds. Typically around 50%.
- Maintenance Margin: The minimum account equity the investor must maintain. Often around 25% of the total market value of the securities.
- Equity: The investor’s own funds in the margin account, calculated as total account value minus borrowed funds.
What Triggers a Margin Call?
A margin call is triggered when the value of the investor’s equity falls below the maintenance margin requirement. This can occur due to:
- A decline in the market value of the securities held
- Increased volatility causing rapid price swings
- Changes in broker margin policies or requirements
- Borrowing additional funds or adding new positions without adding equity
For example, if you buy $10,000 worth of stock using $5,000 of your money and $5,000 borrowed from the broker, and the stock value drops to $7,000, your equity would fall to $2,000. If the maintenance margin is 25%, your account would require $1,750 in equity, and you would still be above the threshold. However, if the stock value drops further to $6,000, your equity becomes $1,000, which is below the required $1,500 thus triggering a margin call.
Types of Margin Calls
There are different types of margin calls based on the broker’s policies and the severity of the shortfall:
Regulatory Margin Call
This occurs when the account falls below the Federal Reserve Board’s minimum initial margin requirement. It typically must be met within a short time frame, usually 4 business days.
Maintenance Margin Call
Triggered when the account equity drops below the brokerage firm’s maintenance requirement. These calls are more common during market downturns or high volatility.
House Call
Also known as a firm-level margin call, this is based on the broker’s internal risk management rules. It may be stricter than regulatory requirements.
How to Respond to a Margin Call
When a margin call is issued, the investor is expected to take action to restore the account to the required equity level. There are several ways to do this:
- Deposit additional cash into the account
- Add more marginable securities
- Sell existing securities to reduce the margin loan
- Transfer funds or assets from another account
If no action is taken by the deadline, the broker may sell securities in your account without notice to cover the deficit. This is known as forced liquidation, and the investor has no control over which assets are sold or when.
Risks Associated with Margin Calls
Receiving a margin call is a serious financial risk, and failure to act quickly can lead to greater losses. Here are some of the risks involved:
- Forced Liquidation: Brokers can sell your investments at a loss without prior approval.
- Loss of Control: You may lose long-term positions or investments you believe will rebound.
- Potential for Greater Losses: If markets continue to decline, equity may evaporate rapidly.
- Debt Obligations: You are still responsible for repaying borrowed funds even if the account value goes to zero.
Preventing Margin Calls
While margin trading can be risky, there are strategies to help avoid margin calls and protect your investments:
1. Monitor Your Account Regularly
Keep a close eye on your portfolio, especially during volatile market conditions. Use alerts and tools provided by your broker.
2. Maintain a Cushion Above Maintenance Margin
Instead of staying close to the minimum margin requirement, try to maintain a higher equity level to reduce the chance of a margin call.
3. Use Stop-Loss Orders
Set stop-loss orders to limit losses on highly leveraged positions. This helps prevent large drops in equity.
4. Avoid Overleveraging
Borrow only what you can afford to lose. Using excessive leverage increases the likelihood of margin calls.
5. Diversify Your Portfolio
Spread investments across different sectors to reduce overall risk. A diverse portfolio is less likely to experience sharp equity declines.
Margin Call Example
Let’s say an investor buys $20,000 worth of stock using $10,000 of their own money and $10,000 borrowed on margin. The brokerage requires a maintenance margin of 25%. If the stock drops to $13,000 in value, the equity in the account becomes:
Equity = $13,000 – $10,000 = $3,000
Now, 25% of $13,000 is $3,250, which is higher than the current equity of $3,000. This shortfall of $250 would trigger a margin call, and the investor would be asked to deposit more funds or sell securities to meet the requirement.
A margin call is a critical warning that your margin account does not meet the minimum equity requirement set by your broker or regulations. It signals that your leveraged investments have declined in value to a point where immediate action is needed to prevent further losses. While trading on margin can increase returns, it also increases risk. Understanding how margin calls work and how to manage them is essential for anyone who uses margin accounts. By maintaining strong risk management habits, staying informed, and acting promptly when needed, investors can use margin more responsibly and avoid the damaging effects of a margin call.