To grasp the concept of a margin call, it's essential to first understand margin trading. When an investor trades on margin, they borrow money from their broker to buy more securities than they could afford with their own funds. This borrowed amount acts as leverage, amplifying both potential gains and losses.
When the value of the securities in a margin account falls, the equity in the account decreases, which can trigger a margin call, a demand from the broker for the investor to add more funds or sell assets to maintain the required margin level.
To understand how margin calls work, it's important to familiarize yourself with a few key terms:
Initial Margin: The percentage of the purchase price that the investor must pay with their own funds when buying on margin. For example, if the initial margin requirement is 50%, an investor must put down $5,000 to purchase $10,000 worth of stock.
Maintenance Margin: The minimum amount of equity that must be maintained in a margin account after the initial purchase. This is typically set by the broker and can vary depending on the type of security and market conditions. Many brokers have their maintenance margin rates at 30-40%, while some have theirs being upwards of 70-80%.
How Does a Margin Call Work?
A margin call occurs when the equity in a margin account falls below the maintenance margin requirement. For instance, if an investor buys $10,000 worth of stock with 50% margin ($5,000 of their own money and $5,000 borrowed), and the stock's value drops to $7,000, the investor's equity becomes $2,000 ($7,000 - $5,000 loan). If the broker's maintenance margin is 30%, the required equity is $2,100 (30% of $7,000). Since the investor's equity is only $2,000, they receive a margin call to cover the $100 shortfall.
How can I go about handling a margin call?
Well, in the first place, you can try not to trade on margin. In doing so, you agree that you are at risk of a margin call and serious losses in the future. Avoiding margin trading may be your best bet, but if you cannot avoid this option, then there are other ways of going about receiving a margin call:
1.) Deposit Additional Funds: The investor can deposit more cash into the margin account to bring the equity back up to the required level.
2.) Sell Securities: The investor can sell some of the securities in the account to reduce the amount of the loan and increase the equity percentage. This can prevent the account from falling further below the maintenance margin.
3.) Do Nothing (Forced Liquidation): If the investor does not take action to meet the margin call, the broker has the right to sell some or all of the securities in the account to cover the deficit. This process, known as forced liquidation, can result in significant losses, especially if the sale happens at unfavorable prices.
Brokers are not obligated to notify investors before selling securities to cover a margin call, leading to unexpected losses and tax implications. If an investor fails to meet a margin call, the broker may liquidate their securities at a loss. This can wipe out a significant portion or even all of the investor’s equity. Additionally, while your leverage can amplify gains, it can also magnify losses. A small decline in the value of securities can trigger a margin call and result in significant losses due to the borrowed amount. Thus, you should be extremely careful with margin trading.
While margin trading can provide opportunities for higher returns, it also carries significant risks, including the potential for margin calls and forced liquidation. Knowing how to manage risk while trading on margin and the potential consequences in doing so can save you your assets, time, and money. In most cases, just avoid margin trading, but if it is necessary, then proceed with lots of caution. Stay learning!
