Margins are a commonly used tool among investors, especially those who take part in day trading. Margins allow traders to increase their buying power with borrowed funds using a mix of their own money and loans from their brokers in a process known as margin trading.
Although margin loans provide an opportunity for substantially larger gains, there’s also potential for substantially larger losses should things go in the wrong direction.
Margin traders also have to worry about the dreaded margin call, which takes place when their account value falls below minimum margin requirements, which could ultimately lead to forced liquidation within their portfolios.
What is a margin call and how does it work? Read on to learn about margin calls and your options should one happen to you.
What Is a Margin Call?
Traders who use margins must maintain a minimum margin requirement, or a minimum amount of value in unborrowed cash and equities in their accounts. This requirement ensures the brokers aren’t left holding the bag on bad trades should things go wrong.
Maintenance margin requirements vary from one brokerage to another, but the minimum requirement will be at least 25% — a requirement set by both the New York Stock Exchange and the Financial Industry Regulatory Authority (FINRA). However, some brokers charge as much as 40% of the amount you borrow.
What’s all of this mean?
When trading on margins, traders take out margin loans to cover a percentage of the value of the securities they are purchasing. For example, you might use $5,000 of your own money and $5,000 of the broker’s money through a margin loan to purchase stock, giving you a total of $10,000 in stock.
In this example, $5,000 of the investment is not your money — it’s borrowed from your broker.
Now imagine your $10,000 investment dropped to $6,250. At this price, after subtracting the $5,000 you borrowed, your personal equity in the investment is down to $1,250.
Because $1,250 represents 25% of the $5,000 margin loan, if the price falls below this point, a margin call would be triggered because the trader’s equity in the investment would fall below the 25% margin requirement threshold.
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Types of Margin Calls
There are two different types of margin calls traders should consider before trading on margins. They include:
Maintenance Margin Calls
Maintenance margin calls take place when the account value falls below the minimum margin requirement with the broker. This is the type of margin call that’s described above. Each broker has a different minimum margin requirement, but the floor for this requirement is 25% of the borrowed amount that you must maintain in your account.
Federal Margin Calls
Federal margin calls are a bit different. While a maintenance-related call has to do with an investment that has already been placed, a federal margin call — often referred to as a fed call — takes place when a margin trade is being initiated.
According to the United States Federal Reserve’s regulation T, margin trades can be placed using a maximum of 50% borrowed money. This is known as the initial margin requirement. For example, if you’re planning on buying $10,000 worth of stock in a margin trade, you’ll have to have at least $5,000 of your own money to put up for that trade.
If you attempt to make a margin trade without having the 50% required to appease the Federal Reserve, a federal margin call will take place, which will lead to one of two outcomes:
- The Trade Will Be Blocked. With most brokers, if you attempt to make a margin trade without meeting the initial margin requirement, the trade will be blocked and cancelled, and you’ll have to set up another trade within the parameters set forth by regulation T.
- Other Securities Liquidated. In some cases, your broker may force the liquidation of other securities in your portfolio to free up the cash needed to make the trade viable.
Either way, the outcome isn’t what investors want.
How to Calculate at What Price a Margin Call Takes Place
Most traders would prefer taking a loss to triggering a margin call. After all, when a margin call is triggered, it means the loss on the investment was so large that it made the trade fall below the minimum requirements.
Most traders calculate at what price a margin call would take place, giving them a baseline of where to close the trade before prices decline to that point.
To determine at what price a margin would happen, follow this formula:
((Margin Loan Amount X Minimum Margin Requirement) + Margin Loan Amount) ÷ Number of Shares = Call Price
For example, let’s say your brokerage firm has a maintenance margin requirement of 30%. You want to buy $10,000 worth of stock with $5,000 of your own money and a $5,000 loan. The stock is worth $50 per share at the moment, meaning that you’ll purchase 200 shares.
Plugging these figures into the formula above would result in the following:
(($5,000 X 0.30) + $5,000) / 200 = $32.50
In this example, if the price of the stock you purchased for $50 per share fell to a market value of $32.50 per share, a call would be triggered, forcing the trader to respond.
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What Are Your Options When You Get a Margin Call?
When you log into your brokerage account and see that a call has taken place, it may be a bit overwhelming. The good news is that you have three options to consider to remedy the situation before a forced liquidation takes place:
- Deposit Additional Funds. The best option is to deposit additional cash into your margin account to bring the cash and equity value of the account up to the minimum requirements. Of course, this only works if you have additional money outside the account that you can afford to add.
- Deposit Securities. The minimum requirements take both cash and the value of securities into account. If you have securities held elsewhere, you can deposit those securities into your margin account to bring the total value of the account up to the minimum requirement.
- Liquidate Stock. Finally, you have the option to liquidate shares of stock within your account, using the funds generated through the liquidation to bring your account value back up to par with minimum requirements.
How to Respond to a Margin Call
Returning to the example above, you know that a margin call will be triggered if the price of the stock falls below $32.50. For this example, let’s say the value of the stock fell to $30 per share. That means the current value of your 200 shares works out to $6,000. However, a call triggers as soon as the value of the investment falls below $6,500, meaning that the margin call is for $500.
At this point, you can choose one of three options:
First, you can choose to deposit at least $500 into your account to bring the account’s value after the margin loan back up to $1,500, or 30% of the total value of the margin loan. This requires adding $500 of new cash into your account, but you don’t need to move or sell any shares.
Deposit Shares of Stock
You also have the option to deposit shares of stock into your account. Say you have another brokerage account where you own $500 worth of stock. By transferring those shares into your margin account, you’ll bring its total value above the minimum margin requirement, bringing your account back into good standing.
Finally, you have the option to liquidate a portion or all of your holdings in the margin trade. Through the liquidation of a portion of your holdings in the investment, you can balance out the minimum requirement and eradicate the issue altogether.
For example, you could choose to liquidate 100 of your 200 shares, the sale of which would result in $3,000 cash at the current share price. These funds would be used to pay back $3,000 of the $5,000 margin loan.
You’re left with $3,000 worth of stock — $1,000 of your own money and $2,000 left of the margin loan — still invested. Your remaining $1,000 holdings are 50% of the remaining $2,000 loan — more than enough to cover your minimum requirement. However, you’ll have realized a substantial loss.
A margin call is nothing that any trader wants to deal with, but if you make the decision to use margins, it will always be a possibility. While margins can expand profitability, they can also result in larger losses, and investors who use them need to consider the extent of these potential losses before getting involved.
Nonetheless, if the risk is worth the reward for you, and you end up with a margin call, don’t panic. Instead, consider which of the three possible remedies to use to bring your account back in line with requirements.
Moreover, if you’re going to trade on margins, treat the trade like any other loan and make sure that you never borrow more money than you can afford to return. In doing so, if and when a margin call does take place, you’ll have the ability to cover the cost if you decide to stay in the investment and await a recovery.