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Margin trading allows investors to purchase securities, such as stocks, with borrowed money. The hope behind the gamble is simple: A loan increases your purchasing power, which can magnify your gains.
But what happens when the investments you made with the money you borrowed aren't doing so well? For starters, you might get what's called a margin call. Here's an overview of what that is, the risks involved and how to avoid it.
Margin call definition
A margin call is a demand made by a broker for an investor to deposit additional funds into their margin account.
Opening a margin account with a broker allows an investor to borrow money for the purchase of securities. To remain in good standing, the investor must maintain a certain balance in the margin account at all times.
Margin calls are issued when the balance in a margin account dips beneath a threshold called the maintenance requirement.
» Need more background? Here’s our primer on margin trading
Understanding margin calls
Because trading with borrowed money is risky, brokers require an investor to keep a certain minimum balance in a margin account as a form of collateral.
In most cases, there are two types of minimum balances that a margin trader needs to be concerned with:
Initial minimum: This is an initial balance that you’ll need to deposit into a margin account to purchase securities with a loan. It is at least $2,000 and needs to initially cover 50% of the total costs of the trade you want to make.
Margin maintenance requirement: This refers to the equity held in the margin account at any given time. Per FINRA, the value of your equity cannot drop below 25% of the current market value of your securities. Depending on your broker and how much you’re borrowing, this percentage requirement can be higher.
By using the value of your margin account as collateral, the lender has a form of protection against your losses should your investments suddenly dip.
You’re obligated to keep an eye on the value of your collateral and make sure it meets that minimum balance at all times. If it drops below the requirement, you must quickly bring the value back up to the maintenance requirement.
» What’s the difference: Cash account vs. margin account
What happens when you get a margin call?
Brokers usually assess the value of an account by looking at its end-of-day trading value. If a margin call is issued, an investor can respond in one of three ways to meet their minimum balance:
Deposit cash into the margin account.
Move securities from another account into the margin account.
Sell some securities in the margin account to pay off the margin loan.
Depending on the brokerage, you’ll likely get two to five days after a margin call is issued to figure out which of the above moves you want to make. If you don’t respond to the margin call, the broker gets carte blanche to decide which securities in your margin account to sell to recoup their losses. They can also liquidate the entire account if necessary.
Note: It’s also entirely possible the broker could sell before giving you the chance to react to the drop in your equity. This can happen if the losses in the associated account continue to dive drastically in a short period of time. The surprise sale of an asset can also increase your tax liability by exposing you to an unplanned-for capital gains tax.
» Learn more: Tax strategies for investing
What causes a margin call?
In a nutshell, the market. But also your decisions. And possibly your broker. Let’s unpack that.
The market: Margin account maintenance is tricky because the value of the investments in the margin account is, for better or worse, directly influenced by the market. That means your margin balance can fluctuate daily based on how your investments are faring.
Your decisions: Making decisions to trade on margin during times of high market volatility can increase the likelihood of triggering a margin call. Staying on top of the current economic climate can help you gauge its potential impact on your investment interests.
Your broker: Your broker can increase your margin maintenance requirement at any time. They could do this for a number of reasons, and without warning. If your account balance fails to meet that new minimum, a margin call will be triggered.
The bottom line: Buying on margin exposes you to the risk of a margin call at any time. If the investments used as collateral experience a decline, that can pull you below that maintenance requirement and trigger a margin call.
Margin call example
Let’s assume you use $20,000 of your cash and a $20,000 loan from your broker to purchase 80 shares of a specific stock at $500 per share, for a total of $40,000.
$20,000 (cash) + $20,000 (loan) = $40,000 (total purchasing power)
80 shares x $500 = $40,000 (total spend)
Now, let’s suppose your broker’s margin maintenance requirement is 35%. Using the following formula, you can figure out how much you need to have in your account to meet that requirement and avoid a margin call:
Loan amount / (1 - maintenance margin) = margin call
$20,000 / 0.65 = $30,769.23
If your total margin account balance falls below $30,769.23, the broker can issue a margin call for you to deposit additional funds.
You can also determine a margin maintenance requirement by calculating how low a stock's share price would need to fall for a margin call to be triggered. First, calculate how much of the loan goes toward each share ($20,000 loan / 80 shares), and then apply the same formula as above:
Total loan per each share / (1 - maintenance margin) = margin call
$250 / 0.65 = $384.62
So, the lowest the share price of your stock can fall before triggering a margin call is $384.62 per share.
How to avoid a margin call
The best method of avoiding a dreaded margin call is to simply avoid trading on margin. But there are several ways you can prepare to meet a call should you receive one.
Read the fine print
When you open a margin account with your broker, you’ll be asked to sign a margin agreement. This agreement might be tucked into the general paperwork you sign with the brokerage upon opening an account, or it could be issued to you separately.
As with all contracts, it’s crucial to review the fine print with care. This agreement will establish important terms and conditions for your margin trading account, including your loan’s interest rates, the repayment schedule, and how you can set your collateral. It will also outline how much you’ll be required to deposit initially and that critical maintenance margin requirement amount.
Hands-on investing requires an active interest in the market’s daily spikes and dips. With margin trading, this kind of interest is not only encouraged but also necessary. Keeping a close watch on your equity requires a daily review of the securities you’ve purchased on margin, the sector you’re investing in and the market at large. This can help you anticipate whether a margin call might be on the horizon.
Financial professionals swear by diversification for many reasons. Spreading out the securities you invest in also spreads out your risk. If one security dips drastically, but others continue to gain traction, you might be able to avoid a margin call.
Have a backup plan
If understanding the risks is part one, then preparing for them is part two. Do the math to understand your financial obligation should a margin call be issued, and be sure you have the assets or cash in hand to respond.
What is a margin call? The bottom line
To recap, a margin call is a risk associated with margin trading, or trading with borrowed money. If your account balance falls below your broker’s margin requirement, your broker may ask you for additional collateral — which could mean selling your investments, or even liquidating your entire account.
You can avoid margin calls by understanding how your brokerage account works, diversifying your investments and staying on top of the latest market news.
These are all easy steps you can take to avoid a nasty surprise from your broker.