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Margin trading allows you to borrow money to buy securities, such as stocks, and make larger investments. While buying on margin can increase your returns, you also face greater risk when investing with borrowed money. Perhaps the biggest risk in margin trading is the dreaded margin call, which can force you to liquidate a large number of stocks quickly, even if at a huge loss.
Definition of margin call
A margin call is a warning that you should bring your margin account again in good standing. You may need to deposit additional cash or securities into your account, or you may need to sell securities to increase the ratio of the assets you fully own to the amount you borrowed.
Before delving into the details of the circumstances that can lead to a margin call – and how you can avoid it altogether – you should first understand how margin trading works.
What does buying on margin mean?
Margin buying is when you use someone else’s money, normally your brokerage’s money, to buy more securities than you would with the cash balance in your account. You access this institution leverage through a special type of brokerage account called a margin account.
If you had $ 1,000 in your margin account, for example, you would be able to buy $ 2,000 of stock using margin. Margin is just another word for a loan, and the cash and securities in your margin account serve as collateral for anything you borrow. When you buy on margin, you are charged an interest rate on the additional amount of money you borrow.
Because of its potential for increasing returns on investment, margin buying is a popular investment strategy for experienced investors. But this can be a very risky approach because you can lose a lot more than the money you invest. You are also responsible for the amount you borrow – and the interest you owe on it – even if the value of the securities you have purchased goes down.
This is why it is particularly important to pay attention to the maintenance margin that you have accepted.
The Financial Sector Regulatory Authority (FINRA) requires brokerage firms to establish maintenance requirements on all margin accounts. These requirements, called maintenance margin, specify the minimum percentage of investments that you must fully hold in your margin account at all times. These requirements are aimed at preventing you from a total default on the loans.
Usually, the maintenance margin is 25%, which means you need to own at least a quarter of what is in your margin account. Some brokerages may have maintenance margin requirements of up to 30% or 40%.
The maintenance margin can be a bit confusing because it is calculated based on the current value of your securities and how much you have borrowed from the brokerage to buy them.
Suppose you borrowed $ 500 on margin to buy stocks worth $ 1,000. You would violate your brokerage’s holding margin if the stock’s value fell to $ 500. In this case, the value of your margin account would be equal to your debt, meaning that you would “own” 0% of your investment in stocks.
In this case, you will receive a margin call and will need to deposit money or sell some of your shares to get back into good standing.
What are the causes of a margin call?
A margin call occurs if the value of your margin account falls below the brokerage company’s maintenance margin requirement. This usually happens when the value of the securities in your margin account goes down. In rare cases, this can happen if your brokerage changes its maintenance margin requirements to a higher amount.
Here is how it could play out. Suppose you borrowed $ 10,000 on margin and combined it with $ 10,000 of your own money. You could then buy $ 20,000 worth of securities. If the market value of your investment drops to $ 16,000, you will only have $ 6,000 in equity. This is because the maintenance margin is calculated based on the current value of the securities minus the amount you owe, which equates to $ 16,000 – $ 10,000 in this case.
If your brokerage firm had a 40% holding margin requirement, you would need at least $ 6,400 in equity in your account (40% of $ 16,000 equals $ 6,400). In this scenario, you would run out of $ 400, so the company could issue a margin call and ask you to deposit or sell securities to make up the difference.
What happens during a margin call?
If your account falls below the brokerage firm’s maintenance needs, the firm will make a margin call and ask you to add money or securities to your margin account. If you cannot meet the margin call, your brokerage firm will sell your securities until your account reaches maintenance margin again.
Brokerages may not always issue margin calls or notify you that your account has fallen below the required maintenance requirement. In some cases, they may choose to sell your securities to bring you back to the maintenance margin without giving you notice.
Make sure you read your company’s margin agreements carefully so that you understand their terms and how they handle margin calls. Reminder: assets liquidated during margin calls are generally sold at a loss.
How to avoid a margin call
You can reduce the likelihood of receiving a margin call by doing the following:
- Leave a cushion of money in your account. Rather than investing all of your money in securities, setting aside some of your money in cash can help avoid margin calls. This is because the value of money is stable and it is still completely yours.
- Anticipate volatility. Diversify your portfolio so that it resists market fluctuations without falling below the maintenance margin.
- Invest in assets with high return potential. This is a good practice when investing using margin in general. You always want to make sure that your investments can earn at least as much as the interest you will incur on your margin loan.
- Make regular payments on your debts. Interest charges are generally charged to your margin account on a monthly basis. However, margin loans normally don’t have a repayment schedule, which means you choose when you make the repayments. By paying off the interest or part of your loan each month, you can keep it from spiraling out of control.
- Set your own minimum. Determine your own maintenance margin above that of your brokerage. When your account reaches this limit, transfer financial resources to avoid a margin call and prevent your brokerage from selling securities.