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What is a Margin Call?
A margin call is a demand from your stock broker to increase the amount of equity that is being held in your account.
This can be done by putting in more cash or by liquidating existing positions that you have in order to generate the required amount of money.
Key Takeaways:
- A margin call is when a broker demands you increase the amount of equity that is being held in your account.
- Brokers may automatically sell your securities if you fall below what is known as the maintenance margin threshold.
- Margin calls can be covered by depositing more cash or margin-eligible securities, as well as by liquidating existing positions.
- You can avoid margin calls by ensuring that you understand your broker’s requirements so you know how much leeway you’ll have in volatile conditions.
- Maintaining a cushion of cash in your account and keeping on top of the performance of investments can help investors handle margin calls.
When Do Margin Calls Happen?
Margin calls happen when the value of securities held in a person’s brokerage account falls below a certain threshold.
This level is also known as the maintenance margin and once passed will generally trigger a demand on the account owner to deposit more cash.
How Margin Calls Work
So, what are margin calls in stocks? According to the US Financial Industry Regulatory Authority (FINRA), the idea is buying securities by using your resources as collateral. The concept of buying a stock on margin involves a brokerage firm lending you cash and using assets in your account as collateral.
It stated: “When you buy stock on margin, your brokerage firm lends you cash, using assets in your account as collateral, to purchase securities.”
What Triggers a Margin Call?
One of the most common is a wave of volatility adversely affecting the value of securities you hold.
However, there are several scenarios that could trigger a margin call:
- The value of your account falls below a set threshold.
- Your broker increases its house maintenance margin requirements.
- You attempt to trade for more than your account will allow.
According to Fidelity, margin calls can be a “stressful experience” with serious financial implications.
It stated: “Your brokerage firm may sell securities you own – without notifying you and without regard to tax consequences – in order to increase the equity in your account.”
Formula for Margin Call Price
There is a mathematical formula that can be used to establish the margin call price.
Types of Margin Calls
There are three types of margin calls in a stock market. It’s important that you know how each of these is defined and what response is required in each case.
How to Cover a Margin Call
So, if you have received a margin call from your brokerage, how should you react? What can you do in order to ensure everything is balanced?
Tips to Avoid Margin Calls
To avoid a margin call, it’s important to understand what triggers them, as well as the steps that can be taken to minimize further risks.
Understand the rules
Take the time to closely read the margin agreement that you have with your broker. Make sure you understand the various terms and conditions.
Know your cushion levels
Check what is known as the maintenance margin excess in your account. This will tell you how much the portfolio can decline in value before a margin call is triggered.
See if the broker issues intraday margin calls
This requires you to understand the broker’s approach to margin calls. Sometimes a call is issued after a big intraday market dip that sees your securities automatically sold.
According to Fidelity, there are several ways to minimize the risk of experiencing a very unwanted margin call from your broker.
Prepare for volatility
Leave a “considerable cash cushion” in your account, suggested Fidelity, in order to protect you from a sudden drop in the value of your loan collateral.
Set personal trigger points
Ensure you have other liquid resources (such as cash) easily accessible that can be added to your account in such a scenario.Monitor your account
Nothing beats keeping on top of your investments. You may even think about setting up alerts that warn you if a stock’s value significantly declines.
Margin Call Example
Let’s use a fictitious example to illustrate a scenario in which an investor may receive a margin call from their brokerage.
The investor buys a security for $10,000, half of which is purchased on margin. This means the loan amount is $5,000. The investor/equity percentage is, therefore, at a healthy 50%.
However, if the value of the security drops to $8,000 (with the loan amount being $10,000) that gives an equity total of $2,000. This is an investor equity percentage of just 25%.
If the broker has a maintenance requirement of 30% then the investor will need to make a deposit in order to push up the above percentage.
In this example, $400 would need to be added as this would give an equity total of $2,400, which when divided by the security value, then multiplied by 100, it works out at 30%.
The Bottom Line
The simplest margin call definition is when a broker is demanding more cash be deposited into your account, so it’s not something that you want to face out of the blue.
In some scenarios, a broker may automatically start selling securities if you fall below this margin threshold. This can have a negative impact on your investments.
However, calls can be avoided. The key is being on top of your broker’s requirements and understanding how they can be affected by valuation fluctuations.
FAQs
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References
- Know What Triggers a Margin Call | FINRA.org (Finra)
- Avoiding and managing margin calls – Fidelity (Fidelity)
- How to handle a margin call | Vanguard (Investor.vanguard)
