Margin calls are demands for additional money made by brokerage firms after cash in an investor’s trading account dips below a required level. They can get triggered after the value of an investment falls in the market, leading to losses in a margin account.
Margin Trading 101
Margin trading allows investors to make trades with some of their own money and with money that is borrowed from their brokerage firm. Regulatory rules limit the amount of cash that an investor can borrow, and brokerages require investors to maintain a fixed level of cash.
The cash balance acts as collateral for the loan that the brokerage firm has provided for the investor to trade. The loan usually includes interest that the investor is responsible for in addition to repayment of the original borrowed amount.
In a cash account, all transactions are made with the funds investors have available, making it unlikely investors will lose more than they initially invested.
Trading on margin allows investors to boost, or leverage, their purchasing power. But in a margin account, investors can end up losing more money than they initially deposited if they’re caught on the wrong side of a trade.
Rules for Margin Trading
Under Federal Reserve Board Regulation T, stock brokerage firms can only lend their customers up to 50% of the initial margin, or the total purchase price for a new purchase.
In addition, the Financial Industry Regulatory Authority (FINRA), a self-regulatory organization, requires investors deposit at least $2,000 in a margin account. For day trading, the minimum deposit amount goes up to $25,000.
FINRA also says that the maintenance margin level should be at least 25% of the market value of all securities in the account.
In the futures market, maintenance margin requirements are set by the futures exchanges and can be lower than for stocks.
Example of Margin Trading With Profit
Here is how a margin trade works. Suppose an investor wants to buy 200 shares of a stock at $50 each for an investment that totals $10,000. He or she puts up $5,000 while the brokerage firm lends the remaining $5,000.
FINRA rules and your broker require that the investor hold 25% of the total stock value in his or her account at all times—this is the maintenance requirement.
So the investor would need to maintain $2,500 in his or her brokerage account. The investor currently achieves this since there’s $5,000 from the initial investment.
If the stock price jumps to $70, the total value of the investor’s holdings rises to $14,000. The broker would add the $4,000 of profit into the investor’s margin account. Including the initial deposit of $5,000, the additional profit leaves $9,000 in the investor’s margin account.
Example of Margin Trading With Loss
If however, the stock’s shares fall to $30 each, the value of your investment also drops to $6,000. The broker would then take $4,000 from the investor’s account, leaving just $1,000.
That would be below the $1,500 required, or 25% of the total $6,000 value in the account.
That would trigger a margin call of $500, or the difference between the $1,000 left in the account and the $1,500 required to maintain the margin account. Normally, a broker will allow two to five days for the investors to cover the margin call.
In addition, the investor would also owe interest on the original loan amount of $5,000.
Margin Call Formula
Here’s how to calculate a margin call:
Margin call amount = (Value of investments multiplied by the percentage margin requirement) minus (Amount of investor equity left in margin account)
Here’s the formula using the hypothetical investor example above:
$500 = ($6000 x 0.25%) – ($1,000)
Investors can also calculate the share price at which he or she would be required to post additional funds.
Margin call price = Initial purchase price times (1-borrowed percentage/1-margin requirement percentage)
Again, here’s the formula using the hypothetical case above.
$33.33 a share = $50 x (1-0.50/1-0.25)
How to Cover a Margin Call
When investors receive a margin call, here are their options to fulfill the demand.
1. They can deposit cash into the margin account so that the level of funds is back above the maintenance margin requirement.
2. Investors can deposit securities that aren’t margined.
3. Investors can also sell the securities that are margined in order to meet requirements.
Risks of Margin Trading
Here’s a rundown of some of the risks that can occur from margin trading.
1. An investor can lose more money than they initially deposited.
2. Brokerages and exchange can make changes to their maintenance requirements quickly, meaning an investor may have to put up additional funds on short notice.
3. Should an investor not have the cash on hand to cover a margin call, he or she may have to sell off investments at an inopportune time.
4. Brokerages and exchanges may sell off investments without consulting the investor to cover a margin call.
5. Investors pay interest on the initial borrowed amount, so are therefore exposing themselves to the risk of rising interest rates.
6. Margin trading can amplify volatility in the stock market. If a selloff in stocks leads to multiple margin calls, widespread selling by investors and brokers to meet those demands may add turbulence to the market.
How to Avoid a Margin Call
1. Investors can understand how margin trading and margin calls work and be aware of their broker’s maintenance requirements.
2. Investors can monitor the volatility of the stock or asset that they are investing in.
3. Investors can set aside money for a margin call and calculate the stock’s lowest price at which their broker might call them for a margin call.
4. Investors can pay close attention to news related to the company or industry that they’re invested in and monitor their margin account closely.
5. Investors can use order types that may help protect them, such as limit orders.
Why Do Margin Calls Exist?
Margin calls are designed to protect both the brokerage and the client from bigger losses.
As many investors turn to margin trading to boost their investments, rules on initial deposits and maintenance can also help reduce systemic risk in the market. Borrowing by margin traders has steadily climbed higher in 2020 and was at $654.3 billion in September. That’s near the all-time high of $668.9 billion reached in May 2018.
Margin calls occur when the level of cash in an investor’s trading account falls below a fixed level required by the brokerage firm. While margin trading allows investors to amplify their purchases in markets, margin calls could result in the investor paying more than he or she initially invested.
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