A margin call is a broker’s demand that an investor deposit additional funds or securities into their margin account to bring it up to the minimum maintenance margin. This occurs when the value of securities in the margin account falls below the broker’s required level.
Understanding Margin Accounts
A margin account allows investors to borrow money from a broker to purchase securities. The borrowed money is subject to interest, and the securities serve as collateral. The goal is to increase purchasing power and potential returns, but it also amplifies losses.
How Margin Calls Work
Initial Margin Requirement
When you open a margin position, you must meet the initial margin requirement, a percentage of the purchase price of the securities.
Maintenance Margin
Over time, the value of securities in the account can fluctuate. A maintenance margin is the minimum account balance required to keep the margin position open. If your account balance falls below this level, a margin call is triggered.
Meeting a Margin Call
When a margin call is issued, investors must either:
- Deposit Additional Funds: Increase the cash balance in the account.
- Sell Securities: Liquidate part of the holdings to cover the shortfall.
- Transfer Securities: Move additional securities into the margin account.
Examples
Example 1: Margin Call Scenario
Suppose an investor buys $10,000 worth of stock on margin with an initial margin requirement of 50%. They initially deposit $5,000, borrowing the other $5,000. If the maintenance margin is 30% and the stock’s value drops to $7,000, the margin call is calculated as follows:
Since the equity ($2,000) is below the maintenance margin requirement ($2,100), a margin call occurs.
Example 2: Responding to a Margin Call
In the above scenario, to satisfy the margin call, the investor needs to:
- Deposit $100 in cash to meet the shortfall.
- Sell securities worth at least $333.33 to restore the required equity.
Historical Context
Margin calls played a significant role in the stock market crash of 1929. Excessive margin trading led to inflated stock prices, and when the market began to fall, widespread margin calls triggered mass selling, exacerbating the crash.
Applicability
Margin calls are relevant in various financial activities, including:
- Stock Trading: Investors seeking to leverage their positions.
- Futures Trading: Accounts falling below the maintenance margin.
- Options Trading: Margin requirements for selling options.
Comparisons
Margin Call vs. Margin Loan
- Margin Call: A demand to increase equity in the margin account.
- Margin Loan: The borrowed funds used to purchase securities on margin.
Margin Call vs. Stop-Loss Order
- Margin Call: Reacts after the account equity falls below a threshold.
- Stop-Loss Order: Preemptive order to sell a security at a specified price.
Related Terms
- Equity: The value of securities in a margin account minus the borrowed amount.
- Leverage: Using borrowed funds to increase potential returns.
- Maintenance Margin: The minimum required balance to keep a margin position open.
FAQs
What happens if I don't meet a margin call?
Can margin calls be avoided?
Are margin calls specific to stock trading?
References
- Investopedia, “Margin Call: Definition, How It Works, and How to Cover One”
- SEC, “Margin: Borrowing Money to Pay for Stocks”
- The Balance, “Understanding Margin Accounts”
Summary
A margin call is a critical concept for leveraged investing, representing a broker’s demand for additional funds to maintain the minimum required balance in a margin account. Understanding the mechanics, meeting requirements, and potential risks associated with margin trading is essential for investors using leverage. By monitoring accounts and preparing for potential margin calls, investors can mitigate unnecessary financial risks and enhance their trading strategies.
