Margin Call Explained

Before you open a margin account, make sure you understand what buying on margin means. Buying on margin is buying more securities than you can afford, using your broker’s money.

Why would you do that? 

"Customers generally use margin to leverage their investments and increase their purchasing power. At the same time, customers who trade securities on margin incur the potential for higher losses."

Financial Industry Regulatory Authority (FINRA) 

What is margin? Margin allows investors to invest in securities by borrowing money from their broker and using the investment as collateral for the loan. Investors use this to buy more stocks than they could afford using just their own funds. Since you are receiving a loan, you have to pay interest on the money you borrow.

Did you know that you can’t use your cash account to trade on margin? You have to open a margin account, which requires a higher minimum account balance than cash accounts. The minimum account requirement is set by the FINRA at $2,000. This is sometimes called minimum margin. Note that the minimum margin may not be enough to cover your broker's initial margin requirement, which is, in general, up to 50 percent of the initial stock purchases. The portion of the purchase price that the customer must deposit is the customer’s initial equity in the account. 

After you bought the stocks on margin, you have to comply with the maintenance margin requirement. It means that you have to keep a minimum amount of equity in your margin account. The equity in your account is the current market value of your stocks minus the debt you owe to your broker. In line with FINRA rules, the equity must not fall below 25% of the current market value of the securities in the account. Otherwise, the customer may be required to deposit more funds or securities in order to maintain the equity at the 25% level.

Brokers are allowed to set their own maintenance margin requirement, which usually varies between a minimum 25% and 40% of equity. The percentage also depends on the volatiity of the stock you bought. This amount has to be maintained in your account at all times. 

"Firms have the right to set their own margin requirements—often called "house" requirements—as long as they are higher than the margin requirements under Regulation T or the rules of FINRA and the exchanges. Firms can raise their maintenance margin requirements for specific volatile stocks to ensure there are sufficient funds in their customers' accounts to cover large price swings."

FINRA

When do you get the dreaded margin call?

One scenario that triggers a margin call is when the value of your assets drops below the initial margin requirement.

You also get the call when the value of your margin account falls to or below the maintenance margin level. Your broker will ask you to restore the account to the original level. If you don’t do as you're told, the broker will liquidate some of your assets. In fact, sometimes your broker may sell off your assets without even making a margin call.

"And here's an important reality check: a firm is not required to notify you of the sale, though most do so as a courtesy; nor does the firm let you choose which securities or assets are sold to meet a margin call."

FINRA

What can you do to avoid a margin call?

First of all, carefully read the margin agreement and understand the terms and conditions. If something is not clear, ask your broker to explain it!

Monitor margin requirements. This includes checking market prices at least on a daily basis. You can try to set market alerts on your broker's web, desktop or mobile trading platform.

In case of adverse price movements that bring you dangerously close to the margin requirement, deposit additional cash into your margin account. And that’s not all! Keep watching the market because you might have to make additional deposits to avoid the call in case the price drop continues.

Some brokers offer tools to help you calculate the impact of equity trades on your margin account. Use them!

Let's have a look at a margin call scenario!

Let's say you have $1,000 and you want to buy stocks on margin.

• Ask your broker to approve you for a margin account
• If you get the approval, you must meet the initial margin requirement. With your $1,000 you can buy $2,000 worth of stocks
• Now you have $1,000 equity and $1,000 debt, a loan from your broker in your margin account. This is called the margin loan balance.

Let's say that your broker has a 40% maintenance margin requirement. Going forward, make sure you always meet this requirement - at the current stock price, this would be $2,000 x 0.4 = $800.

What happens if the price of the stock rises by 25%?

• In this case, your account is worth $2,500.
• If you decide to sell the shares, you make $2,500 - $1,000 = $1,500 after you pay back the $1,000 loan to your broker. That’s a 50% return on your initial investment of $1,000. Not bad, right?

What happens if the stock price drops by 25%?

• The market value of your stocks is now at $1,500.
• The equity in your account drops to $1,500 - $1,000 = $500. Remember, this is the current market value of your stocks minus the debt you owe to your broker.
• With a market value of $1,500, you would need to maintain equity of $1,500 x 0.4 = $600 in your account to meet the maintenance margin requirement.
• A margin call will be issued on your account because you don't meet the margin requirement.
• You will be required to urgently deposit cash or sell off some of your securities to meet the margin requirement again.
• Remember that your broker may sell your stocks without calling you first!