A margin call (MC) is one of the main risks of margin trading. The investor faces an MC when the account value drops below the required minimum value.
What Is Margin Call?
It is a requirement for the investor to pay a certain amount of cash or stock when the amount of cash in their margin account falls lower than a specific level. In the United States, this level is determined by the Federal Reserve Board Regulation T. You must have enough cash in your MA to equal 25 % of the total price of the stock that you own. If you do not have enough cash in the account, your broker can issue an MC requiring you to deposit enough money to reach the 25% maintenance level.
Many brokers have their own requirements – the so-called house requirements. The minimum maintenance margin for the house requirements is typically between 30 and 40%.
Example of a Margin Call Risk
Let’s suppose that you buy $ 50,000 of stock on margin and pay $ 25,000 of the initial margin. If the stock price drops to $ 30,000, you lose $ 20,000 and have $ 5,000 in your account. According to the margin trading rules, you must have at least 25 % of the $ 40,000 stock value in your MA, which is $ 7,500 – and some brokers may require even more. Thus you will have to deposit an additional $ 2,500 in your account to avoid an MC and subsequent liquidation.
Rules of a Margin Call
The U.S. Securities and Exchange Commission (SEC) recommends that the investors should study their MA agreements very carefully. Never sign an agreement with a broker without reading the fine print and fully understanding the risks of borrowing the funds to buy stock.
The trickiest feature of MCs is that they occur suddenly and without any warning. By law, brokers are not required to warn the account holders about the low deposits and have the right to liquidate (sell) the assets without prior notice. So the MA holder must constantly check their account to maintain the margin.
Even if the broker issues an MC, they can start selling your stock while waiting for you to make a deposit. Such forced liquidation of stock deprives the investor of any opportunity to get their money back.
Other pitfalls are as follows:
- It is impossible to choose the stocks that your broker will sell to cover the maintenance margin.
- You must pay the margin call immediately, without any time extensions.
- The broker can change their house requirements any time they want and issue an MC based on the new requirements.
Therefore, the golden rule of margin trading is to avoid MCs at all costs. The best way to do that is constant monitoring of your investments to make sure you have enough funds in your MA to cover the maintenance requirements. You should open an additional cash account from which you can quickly transfer the funds into the MA.
Margin trading is quite a risky venture, mainly because of margin calls that occur because of unexpected stock price fluctuations. You must always have cash in your account that typically equals 25 % of the stock price – a maintenance margin - though some brokers may require a higher percentage. Therefore, you must study the account agreements very carefully and constantly monitor your account to maintain the requirements – otherwise, you may get a margin call and lose all of your assets unexpectedly. Remember to avoid margin calls whenever it is possible.