Investing: What is a Margin Call? How Does it Work & a Helpful Example

By Chika

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Last Updated: April 30, 2022

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Investors are always looking for avenues to boost portfolio returns. One of such ways being explored by investors with a high appetite for risk is through margin trading. This is when an investor borrows money from a brokerage firm to make trades.

However, margin trading not only increases your chances of making a profit with little capital but also amplifies your chances of a loss. In such a scenario, you may get a margin call from your broker instructing you to increase your deposit to cover any potential loss.

This was aptly exemplified by the Archegos capital blowup which saw the trading firm's CEO, Bill Hwang, have arguably the largest margin call ever, which forced him to unload $20 billion of shares to cover his margin. 

Margin trading, if used efficiently, can increase profits. However, diligent traders always take cognizance of margin calls before borrowing from their brokerage. Let's take a closer look at how margin calls work, as well as how to avoid or cover a margin call.

 

What is a Margin Call?

When a brokerage business asks that an investor contribute cash or equity to their margin account because it has fallen below the requisite amount, this is known as a margin call. This usually occurs after a decline in the value of investments purchased with borrowed funds from a brokerage firm, a situation known as margin debt.

A house call, sometimes called a maintenance call, is a type of margin call. When the market value of assets in a trader's margin account falls below the necessary maintenance margin - the minimum amount of equity a trader must keep in their margin account – a brokerage company may issue a house call.

If the investor does not comply with the margin call, that is, does not contribute cash or equity to their account, the brokerage may liquidate the customer's assets without notice to satisfy the account's deficiency.

 

 

How Do Margin Calls Work?

A brokerage company will issue a margin call if the equity in an investor's margin account falls below the maintenance margin. Brokers have different criteria for maintenance margins.

Furthermore, regulatory authorities such as the Federal Reserve and the Financial Industry Regulatory Authority (FINRA) have account minimums requirements that all corporations and investors must observe in order to reduce risk and leverage.

Regulation T

The initial margin amount should be at least 50% of the market value of all securities in the margin account, according to the Federal Reserve Board's Regulation T.

The minimum equity amount must be equal to or more than 50% of the entire value of the margin account. A $10,000 deal, for example, would have an investor putting $5,000 of their own money into the transaction.

FINRA

After purchasing on margin, the Financial Industry Regulatory Authority (FINRA) requires investors to maintain a maintenance margin of at least 25% of the market value of all assets in the account.

In a $10,000 deal, for example, the investor must keep $2,500 in their margin account. The investor will be susceptible to a margin call if the investment value falls below $2,500.

 

Example of Margin Call

The following is an illustration of how a margin trade works.

For instance, suppose an investor wants to invest $10,000 in 200 shares of a stock for $50 each. He or she puts up $5,000 and the brokerage business lends the rest of the money.

The investor must maintain a minimum of 25% of the entire stock value in his or her account at all times, according to FINRA standards and your broker. As a result, the investor must keep $2,500 in his or her brokerage account. Because there is $5,000 leftover from the first investment, the investor is now able to do so.

If the stock decreases to $30 per share, the value of your investment lowers to $6,000. After then, the broker would deduct $4,000 from the investor's account, leaving him with only $1,000. That's less than the $1,500 necessary, or 25% of the account's entire worth of $6,000.

This would result in a $500 margin call or the difference between the $1,000 in the account and the $1,500 needed to keep the margin account open. Typically, a broker would give investors two to five days to cover the margin call. In addition, the investor would be responsible for the interest on the $5,000 loan.

 

 

How to Calculate Margin Call

Here’s how to calculate a margin call:

Margin call amount = (Value of investments X percentage of margin requirement) - (Amount of investor equity left in the margin account)

Using the formula we can calculate the above example:

$500 = ($6000 x 0.25%) – ($1,000)

Investors can also calculate the share price at which they would be required to post additional funds.

Margin call price = Initial purchase price times (1-borrowed percentage/1-margin requirement percentage)

 

 

Covering a Margin Call

There are a number of options investors can use to cover their margin calls. They are: 

  1. Deposit cash into the margin account so that the level of funds is back above the maintenance margin requirement.
  2. Deposit securities that aren’t margined.
  3. Sell securities that are margined in order to meet requirements.

 

 

Tips on Avoiding Margin Calls

Avoiding trading on margin or having a margin account is the greatest strategy to prevent a margin call. Margin trading should be reserved for individuals who have the time and intelligence to adequately monitor their portfolios and accept the risk of significant losses.

To prevent a margin call, investors who trade on margin might take a few steps.

  • Understand margin trading: Investors can understand how margin trading works and know their broker’s maintenance margin requirements.
  • Monitor the market: Investors can monitor the volatility of the stock, bond, or whatever security they are investing in to ensure their margin account doesn’t dip below the maintenance margin.
  • Have emergency funds: Investors can set aside money to fulfill the potential margin call and calculate the lowest security price at which their broker might issue a call.
  • Make use of limit orders: Investors can use order types that may help protect them from a margin call, such as a limit order.

 

 

Key Takeaway on Margin Calls

The retail frenzy in the stock market has led to an increase in margin debt.

Investor borrowing from brokerages reached its highest point in two years as investors borrowed a record $722.1 billion against their investment portfolios through November 2020, topping the previous high of $668.9 billion from May 2018. This also translates to multiple blown accounts and trading losses. 

Margin trading allows investors to increase the size of their market purchases. But they may cause the investor to pay more than he or she originally paid. Margin calls happen when the amount of cash in a trader's account goes below a certain amount set by the brokerage business.

The best approach to trading and investing is a conservative risk-averse approach. Always keep the long game in mind, and avoid the urge to make quick gains. This is exactly how the market sucks people in. 

Photo by Karolina Grabowska

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