What is Margin Call in Stocks?

A margin call is a situation that occurs when an investor’s margin account value decreases below the broker’s required amount. The margin account is the account that holds all an investor’s borrowed securities or securities purchased with borrowed money. The last thing any trader or investor with a margin account looks forward to at the end of the day is a margin call especially when such a person cannot afford it.

What is Margin?

A margin is a form of collateral that an investor or holder of a financial instrument deposits with a broker or an exchange to cover credit risks in a trade. This collateral would be used to cover risks such as borrowing money to buy securities or borrowing securities to short sell them or entering a derivative contract. In the United States, margins were formerly known as performance bonds.

While a margin account is a loan account opened by a holder of financial instruments with a broker. The funds in this account can be used for share trading and they are determined by the broker depending on the securities involved. The broker is responsible for monitoring the holder’s trading interests based on the strength of their margin account. The broker is also authorized to set a percentage of value per security it is willing to allow the trader to proceed with. It also has the right to make a ‘margin call’ if the available balance decreases below the utilized amount.

Margin Buying

The process of margin buying is quite straight forward yet highly risky. An investor can use margin to buy or sell securities by using a combination of his/her own money and money borrowed from their broker. The investor’s equity in the investment is derived from deducting the borrowed funds from the market value of the securities (i.e., equity = market value – borrowed funds)

For example, Todd buys a share in a company for $100 using only $20 of his own money and borrowing the remaining $80 from his broker. The broker would require a minimum margin amount of $10 of the $20 net value (net value = share price – amount borrowed). Assuming the share price falls to $85, the net value will be $5 (i.e., the previous net value of $20 – shares price drop of $15). To maintain the broker’s minimum margin, Todd would have to increase the net value to $10 or more by either repaying part of the loan or selling the share.

With margin buying, you can borrow up to 50% of the price of a stock from your broker. If a stock price is $200,000, the amount you will pay is $100,000 (50% of the stock price) while your broker will cover the other $100,000. If the stock price eventually increases to $225,000, you will have a chance of making a 50% return on your investment. However, if the stock price drops to $175,000, you will lose 50% of your investment while your broker owing a 2% interest.

Understanding Margin Call

A margin call is a demand for additional funds or securities to meet up the minimum maintenance margin in a margin account. This usually happens when the account holder is below the broker’s standard requirement on a margin account. To meet up this margin call, brokers may be mandated to use force to make traders sell their assets if the trader isn’t able to deposit funds to meet the margin call. However, if a margin call is met immediately the broker will not be compelled to use force to liquidate the securities in the margin account. Usually, a margin call happens when an investor’s equity falls below the percentage requirement of the broker, also known as the maintenance margin. There are no fixed percentages, however, the NYSE and FINRA have a requirement for investors to maintain at least 25% of the total value of their securities as margin. It differs according to brokerage firms as some require between 30% to 40% maintenance margin. The Federal Reserve Board requires that for anyone who seeks to own a margin account, such a person must have enough equity (cash) to cover the maintenance margin. The minimum requirement is 25% of the total price of the stock the investor owns.

There is a high risk associated with margin buying in that a large proportion of the money used to buy securities is borrowed. It not only has a high potential of making an investor lose their entire investment and interest, but also lose additional money on a margin call. Nonetheless, it is also has a number of benefits and big investors who fully understand the risks involved can make lots of money through buying on margin.

The broker has the right to, at any time, change the value of the collateral securities or margin regularly. The decision to make changes can be done after estimating the risk involved such as other market factors. From time to time, the broker will use a margin call to keep the borrower in step with the margin account average.

On the other hand, if a margin call happens unexpectedly at different times it can eventually cause a “domino effect” or create a ripple in the market which would lead to other margin calls until it crashes a group of asset classes. This usually occurs when there is an increase in margin requirement or when there is a change in the market value of the leveraged asset. Increased market volatility can also be a cause.

Margin calls prices differ as they are mostly dependent on percent of the margin maintenance and equities involved. However, in the case of an individual investor, there is room for calculating the exact stock price which can trigger a margin call. The account value or account equity would equal the maintenance margin requirement (MMR).

It can be represented as thus;

Account Value = (Margin Loan) / (1 – MMR)