What is a Margin Call?
When you trade on the margin, you trade in securities with a mix of your own funds and borrowed money, usually loaned from a broker. If you often end up trading on the margin and your equity-debt ratio dips, you are essentially signing yourself up for a potential margin call.
As an investor, you pledge the security and cash in your account as collateral and take out a margin loan to enhance your purchasing power. If you qualify for a margin, then the broker can even lend up to 50% of the total cost of the asset. As long as the value of the asset is rising, the investor makes a profit. At any point of time as the required equity in your account drops below the set minimum level, the broker is triggered to make the margin call to you asking to immediately boost up your account value to the level of the maintenance margin. You can perhaps do this either by putting down supplementary funds or dissolve your asset holdings, or a combination of both.
In case you are unable to replenish your account up to the required level, your broker may be forced to dissolve your assets to flush the account, with no regard to the current market prices. A margin call might be one of the most undesirable and unpleasant experiences for any trader or investor.
A majority of regulatory bodies in the USA require investors to set apart a minimum of 25% of total security value as margin. However, this percentage may rise, depending on the brokerage firm you commit to.
You can calculate the exact value your stock has to fall to set off a margin call.
Account Value =((Margin Loan)/(1-Min. Maintenance Margin))
For instance, say the minimum maintenance required by the brokerage firm is 25% and your investment capital is $10,000. You want to purchase 200 shares of $100 each, i.e. a total purchase of $20,000. To complete the purchase, you need to borrow $10,000 from the broker as margin loan. According to the formula mentioned above, a margin call will be initiated when the account value diminishes below –
Account Value = 10,000 / (1 – 0.25) = $ 13,333.33.
Say the value of the account dips to $13,000, this will force your broker to initiate a marginal call of $333.
What to Do After a Margin Call?
Once a margin has been initiated, you have limited options to get back to the minimum requirement level. The easiest way out would be to promptly deposit the deficient amount into the account. However, you may not have the bandwidth to do so – you can deposit securities that have been fully paid from your other margin account with the same broker or even sell securities from the margin account to meet the margin call.
In case you fail to respond to the margin call in time, your broker has the option to close the open positions to clear off the debt. The brokerage firm can even trade the securities without giving any notice, as per the terms and conditions of the agreement signed between the two parties. The broker may even force you to pay commission and interest on the money the investor had borrowed.
A margin call may lead to more severe consequences if you aren’t able to clear the debt even after all the adjustments have been made. Moreover, your credit scores and the insurance rates will be adversely affected and your broker may even sue you in court.
How to Avoid Margin Calls?
Here are 5 things you should keep in mind to avoid margin calls –
Understand Trading on the Margin – Even before you open a margin account, understand the benefits and the pitfalls of trading on the margin. The first step really is to understand what you are getting yourself into. Read through the agreement carefully and understand what can trigger a margin call and the consequences if you fail to respond.
Understand Margin Requirements – Prior to opening a trade, you must have a clear understanding of the margin requirements. Go through the in-house rules of the broker or the firm and monitor the margin level. When you open a trade position – keep in mind the margin amount that will be deducted and ensure you leave some room to maintain the margin.
Use Stop-loss – A stop-loss is an order to halt the trade or close your position to avoid excessive losses. Having a stop-loss order in place will automatically generate an instruction to stop trading when prices dip beyond a limit, post which you wouldn’t want to risk massive loss. Specify a limit above the maintenance margin because if you keep trading without a stop loss, you may end up triggering a margin call.
Trade Smartly – Don’t run after quick profits – instead trade smartly and have a risk management strategy in place. Trading on the margin does allow some comfort however always be mindful to not use up your purchasing power. Instead, give yourself some margin – you may judge price movement wrongly and put yourself at risk. Be smart about your positions – diversify your portfolio to avoid concentrated losses. It is advised to avoid trading on the margin as far as volatile securities are concerned.
If you’re a relatively new trader, trading on the margin might seem attractive as it allows you to reap profits with limited funds. It is always better to not get carried away because getting a margin call may be a very unpleasant wake-up call. Remember, managing risk precedes profits. Understand what you are getting into, know your limits and when to cut your losses, diversify your trades and you can take full advantage of trading with margin to grow substantial profits.