Margin calls are demands for additional money made by the brokerage firm. Margin calls occur when the value of an investor’s trading account dips below a required level.
In a cash account, all transactions are made with the funds investors have available. Meanwhile, in a margin account, investors can make trades with their own money and with money that is borrowed from their broker.
Hence, brokerages often require investors to maintain a fixed level of cash. Margin calls are designed to protect both the brokerage and the client from bigger losses. Here’s a closer look at how margin calls work, as well as how to avoid or cover a margin call.
Rules Around Margin Calls
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.
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Example of Margin Call
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’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.
How Long Do I Have to Cover a Margin Call?
Brokerage firms are not required to give investors a set amount of time. As mentioned in the example above, a brokerage firm normally gives customers two to five days to meet a margin call. However, the time given to provide additional funds can differ from broker to broker.
In addition, during volatile times in the market, which is also when margin calls are more likely to occur, a broker has the right to sell securities in a customer’s trading account shortly after issuing the margin call. Investors won’t have the right to weigh in on the price at which those securities are sold. This means investors may have to settle their accounts by the next trading day.
How to Avoid a Margin Call
Here are some steps investors can take in order 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 use order types that may help protect them, such as limit orders.
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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.
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. Margin calls occur when the level of cash in an investor’s trading account falls below a fixed level required by the brokerage firm.
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