A margin call, though not a term that is foreign to seasoned investors, can send shivers down the spine of anyone trading on margin. In this article, we'll delve into the intricacies of what a margin call is, what triggers it, and how to navigate its financial implications. Let's demystify the concept of margin calls.
A margin call is a request for funds from a broker when money must be added to a margin account to meet minimum capital requirements. It happens when the percentage of an investor's equity in a margin account falls below the broker's required amount. A margin account typically comprises securities bought with a combination of the investor's own money and money borrowed from the broker.
The crux of a margin call is the broker's demand that the investor deposit additional money or securities into the account. This is to ensure that the value of the investor's equity and the account value rises to a minimum value as stipulated by the maintenance requirement.
What Triggers a Margin Call?
A margin call is triggered when the investor's equity, as a percentage of the total market value of securities, falls below a required level, known as the maintenance margin. The regulatory bodies, such as the New York Stock Exchange (NYSE) and the Financial Industry Regulatory Authority (FINRA), require investors to maintain an equity level of 25% of the total value of their securities when buying on margin. However, some brokerage firms may have higher maintenance requirements, ranging from 30% to 40%.
Margin calls can occur at any time due to a drop in account value, but they are more likely to happen during periods of market volatility. Let's illustrate this with an example.
Example of a Margin Call:
Imagine you've bought a security for $20,000, with half the amount borrowed on margin. Your initial equity in this investment is $10,000 (50%). Now, if the security's value drops to $14,000, your equity diminishes to $4,000 (28%), below the maintenance requirement of $4,200 (30%). This triggers a margin call for $200.
How to Cover a Margin Call
When a margin call is issued, investors usually have two to five days to meet it. Here are some ways to cover a margin call:
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Deposit Cash: Deposit the required amount in cash into your account.
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Marginable Securities: Deposit marginable securities (fully paid for) into your account. The amount needed can be calculated by dividing the required funds by (1 less the equity requirement). For example, in the case above, $200 divided by (1 - 0.30) equals $285.
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Combination: Use a combination of the above options.
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Sell Securities: Sell other securities to obtain the needed cash.
Failing to meet a margin call can lead to the broker closing out open positions, potentially incurring commissions, and holding the investor responsible for any resulting losses.
How to Avoid a Margin Call
To avoid margin calls, investors can take several steps:
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Maintain Adequate Cash: Ensure cash is readily available to cover margin requirements.
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Diversify Your Portfolio: Build a diversified portfolio to limit the risk of a margin call.
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Regular Monitoring: Keep an eye on open positions, equity, and margin loan regularly.
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Set Alerts: Set up custom alerts to notify you if your account approaches the margin maintenance requirement.
In addition, consider using protective stop orders to limit losses in equity positions.
Is It Risky to Trade Stocks on Margin?
Trading on margin is inherently riskier than trading without it. This is because margin trading involves borrowed money, making leveraged trades riskier. The biggest risk is that investors can potentially lose more than they initially invested.
Can a Trader Delay Meeting a Margin Call?
A margin call should be satisfied immediately, and brokers may have the right to liquidate assets held in the margin account without notice if the call is not met promptly. Thus, it's advisable to rectify margin deficiencies promptly.
Managing Risks Associated with Margin Trading
To manage risks, traders should use stop-loss orders, maintain manageable leverage, and diversify their portfolio to reduce the likelihood of a margin call, especially with a single stock.
Total Level of Margin Debt and Market Volatility
A high level of margin debt can exacerbate market volatility. During sharp market declines, forced selling to meet margin calls can trigger a vicious cycle of falling stock prices, leading to more margin calls and more selling.
In sumamry, understanding margin calls is crucial for any investor using margin. By managing your investments, maintaining sufficient cash, and being prepared for potential margin calls, you can navigate the world of margin trading with confidence and minimize the risks associated with it.
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