A margin call occurs when your brokerage firm issues an immediate request for additional funds or securities in your margin account – a type of account where the broker lends investors cash to purchase securities. This can happen when the total amount in the account falls below the requirements set by the brokerage’s internal rules or federal regulatory agencies.
How does a margin call work?
A margin call works by forcing the investor to bring the margin account back to the required minimum levels if they end up with a significant debt compared to the value of the securities in their brokerage account. A margin call can occur as a result of a decrease in account balance, a decline in the value of securities, or another violation of the broker’s margin account requirements.
Brokers are available to set their own rules, but under the regulations put forth by the Financial Industry Regulatory Authority (FINRA) and the Federal Reserve, the broker can lend up to 50% of the security’s price on margin. After the purchase, they will monitor the value of your securities against the debt.
The minimum amount of equity you must maintain in your account is called maintenance margin. While 25% is the lowest legally allowed requirement, many brokers set the limit at 30% or 40%. However, some securities may require as much as 75% to 100%.
Brokers have automated systems to monitor client equities and programs that will issue a warning, notification, or action if these equities fall below the required levels.
When facing a margin call, you can respond by selling securities to meet the maintenance margin requirement or by adding cash to your account. If you do neither, your broker can sell your investments without your consent to cover your debts. The broker can even do this without contacting you.
Note: You will likely not be able to purchase more securities until you meet the margin call requirements.
Margin requirements protect both the investor and the brokerage firms, and shield the market from volatility and bubbles caused by excessive speculation in securities. Widespread borrowing for speculation was a contributing factor to the stock market crash of 1929. A margin call means that brokers will not lose massive amounts of unpaid loans. It also somewhat protects investors from catastrophic losses by forcing them to sell positions they cannot afford.
Imagine a scenario where someone could borrow hundreds of thousands or millions of dollars to invest in a company. If the stock price of that company drops by just a few dollars, the investor could easily lose more money than they have. This could leave investors bankrupt and brokers losing significant amounts of money.
Note: Rules may vary for certain types of traders or securities. For example, forex traders can leverage their positions up to 50:1 for major currency pairs.
Example of a margin call
To determine whether you meet the maintenance margin requirements, multiply your account balance by the maintenance margin. If your equity (what you own) is less than that value, your broker will initiate a margin call.
Let’s say John wants to invest in XYZ Company, which is trading at $100 per share. John has $50,000 to invest and wants to buy as many shares as possible. Using margin, he can buy 1,000 shares using his own money and $50,000 on margin from his broker. In total, John now owns securities worth $100,000.
Then, the stock price of XYZ Company drops to $60 per share. John will only have $10,000 of equity compared to $60,000 of securities in his account. This will trigger a margin call because:
$60,000
× 0.25 = 15,000 (amount of equity required from John)
10,000 less than 15,000
John must make a decision, which may include a deposit or cash transfer, or more possible XYZ shares for margin, or closing positions to bring his account up to the required level of $15,000. If John does nothing, his broker may sell his shares in XYZ without contacting him.
Avoiding a Margin Call
If you are concerned that a margin call may happen soon due to market fluctuations or a rapid decline in stock prices, you have some options – but you also need to consider the tax implications that may arise.
To avoid a margin call in the future, plan how you will act in case of a decline in stock price and how you will handle a potential margin call. This may mean borrowing less than allowed, maintaining a personal margin higher than the broker’s margin, diversifying, and monitoring your portfolio more closely.
Investors can also use cash accounts to pay for purchased securities. Cash investment accounts may come with additional restrictions, such as not being able to buy and sell a security before paying for it.
Frequently Asked Questions (FAQs)
What is a margin call in day trading?
A margin call in day trading, or DT margin call, is a margin call for people who trade on the same day or buy and sell their positions within the same day. If you consider yourself a day trader, specific rules apply to your margin account, including minimum equity requirements. Read your broker’s instructions on how to avoid a DT margin call.
What is a margin account?
When investors use a margin account, they can borrow money from their broker to increase their buying power. This borrowed money is called margin. Margin is useful because it can increase the investor’s potential returns. However, it also increases potential risks and raises the broker’s risk as they may have lent money to someone using margin to buy potentially volatile assets.
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Sources
The Balance uses only high-quality sources, including peer-reviewed studies, to support the facts in our articles. Read our editing process to learn more about how we verify facts and keep our content accurate, reliable, and trustworthy.
FINRA. “Margin Regulation.”
U.S. Securities and Exchange Commission. “Investor Bulletin: Understanding Margin Accounts.”
Charles Schwab. “Your First Margin Call.”
Oanda. “Spreads and Margins.”
Source: https://www.thebalancemoney.com/margin-call-trading-definition-1031300
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