What is a Margin Call?
A margin call occurs when the value of a margin account falls below the account’s maintenance margin requirement. It is a demand by a brokerage firm to bring the margin account’s balance up to the minimum maintenance margin requirement. To satisfy a margin call, the investor of the margin account must either deposit additional funds, deposit unmargined securities, or sell current positions.
The Federal Reserve’s Regulation T sets the maintenance margin to at least 25% of the investment. However, some brokers may set their maintenance margin to 30% or 40%, depending on the broker’s regulations. Brokerages implement such rules to protect themselves against the risk of customer defaults. It ensures that there is sufficient collateral in the customers’ margin account.
Understanding Margin Calls
When a margin account balance runs low below the required minimum margin, a broker issues a margin call to the respective investor. A margin call is a broker demand requiring the customer to top up their account, either by injecting more cash or selling part of the security to bring the account to the required minimum.
The customer is allowed a short grace period to take the required action to meet the margin requirements. If the customer does not respond to the margin call, the broker may dispose of part of the securities to restore the account to the required margin level.
Financial regulators such as the Financial Industry Regulatory Authority (FINRA) require brokerages to set margin requirements for customer trading accounts. If the customer’s account falls below the required minimum balance, the brokerage may not always issue a margin call to the customer, requiring them to top up the account. Instead, they may sell part of the customer’s securities to restore the margin account to the maintenance margin without notifying the customer.
Formula for Margin Call Price
The formula for margin call price is as follows:
- Initial purchase price is the purchase price of a security;
- Initial margin is the minimum amount, expressed as a percentage, that the investor must pay for the security; and
- Maintenance margin is the amount of equity, expressed as a percentage, that must be maintained in a margin account.
Example of a Margin Call
An investor is looking to purchase a security for $100 with an initial margin of 50% (meaning the investor is using $50 of his money to purchase the security and borrowing the remaining $50 from a broker). In addition, the maintenance margin is 25%. At what price of the security will the investor receive a margin call?
The investor will receive a margin call if the price of the security drops below $66.67.
Interpreting the Example Above
To further break down the example above, we can interpret it as:
- The investor is purchasing a security for $100 using $50 of his own money and $50 from a broker; and
- The broker’s maintenance margin is 25%, meaning the investor’s own money must comprise at least 25% of the security.
By determining the margin call price, we are determining the minimum price the security can trade at without falling below the maintenance margin. In the example above, the margin call price is $66.67 because:
- Since the broker lent $50 for the investor to purchase the security and the security is trading at $66.67, the broker’s lent money comprises 75% of the investment ($50 / $66.67), and the investor’s own money comprise 25% of the investment ($66.67 – $50 / $66.67).
Therefore, at the price of $66.67, the broker keeps a 75% position in the security, and the investor holds a 25% position in the security: the margin call price.
If the price of the security falls below $66.67, say $60, the broker would comprise 83.33% ($50 / $60) of the investment, and the investor would comprise 16.66% ($60 – $50 / $60) of the investment. Seeing that the investor now only holds a 16.66% equity position in the investment, he would receive a margin call.
How to Cover a Margin Call
If a margin call is not satisfied, the broker can liquidate the investor’s position. For example, if the investor in the example above did not satisfy the margin call when the price fell to $60, the broker would liquidate the investor’s position at $60 and retrieve the $50 owed by the investor. The investor would face an 80% realized loss, as he is now left with only $10 from his initially invested amount of $50.
A margin call can be covered through:
- Depositing additional funds to meet the account’s maintenance margin requirement;
- Depositing unmargined securities to meet the account’s maintenance margin requirement; or
- Selling margined securities to meet the account’s maintenance margin requirement.
How to Avoid a Margin Call
1. Leave cash cushion in the account
Instead of investing all the money in financial products, the investor can set aside some cash deposits to help avoid margin calls. Cash offers a stable value and will remain intact even when the value of securities fluctuates.
2. Plan for volatility
An investor can diversify his/her portfolio by holding different types of securities. The financial products may comprise stocks, bonds, commodities, and derivatives. A diversified portfolio can help the investor withstand unpredictable financial market fluctuations without plummeting below the maintenance margin.
3. Invest in assets with high return potential
High-return assets can help investors earn sufficient returns in the short-term. Buying short-term assets with a high return potential can help the investor earn enough return to pay the margin loan and interest and still earn a profit.
4. Make regular payments
Interest charges are applied to the investor’s account every month. Since margin loans do not come with a specific repayment schedule, the investor should formulate a clear plan to pay interest charges regularly as they are due. Making regular interest payments every month will help avoid loan accumulation and keep the outstanding loan balance in control.
5. Set an investor’s minimum
Investors should set their own maintenance margin, which should be above the broker’s minimum required balance. When the margin account balance falls that limit, the trader should top up the account to increase the balance. Such a strategy can help an investor avoid margin calls and a forced sale of high-potential securities.
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