A margin call is a broker’s demand for an investor to deposit more money or securities into a margin account when the value of existing positions falls below the required maintenance level. This demand is triggered when the account’s equity, as a percentage of the total market value of securities, falls below a certain percentage requirement, which is called the maintenance margin.
Understanding Margin Calls
Investors typically use margin accounts when they want to invest in stocks, using leverage to amplify their returns. However, trading on margin also increases the potential losses, as losses are amplified when the market moves against the investor’s position.
The Trigger Point
When an investor buys on margin, they are essentially borrowing money from the broker to make the investment. The securities purchased act as collateral for the loan. The initial amount of cash deposited by the investor is known as the margin, and the rest is loaned by the broker. The Federal Reserve sets the initial margin requirement, which is the minimum amount of cash that must be deposited by the investor, typically a percentage of the total market value of the securities being purchased.
Maintenance Margin
Once the investor has bought securities on margin, they must maintain a certain level of equity in their account, known as the maintenance margin. This is a minimum percentage of the total market value of the securities that must be maintained at all times. If the value of the securities falls and the equity in the account drops below the maintenance margin, the broker will issue a margin call.
The Margin Call Process
When a margin call occurs, the broker will typically contact the investor and demand that they deposit additional cash or securities into the account to bring the equity back up to the maintenance margin level. If the investor fails to do so, the broker may sell some or all of the securities in the account to cover the loan. This is known as a margin liquidation.
Example of a Margin Call
For example, let’s say an investor buys $10,000 worth of stock on margin, with an initial margin requirement of 50%. This means they must deposit $5,000 of their own cash and borrow the remaining $5,000 from the broker. If the value of the stock falls to $7,000, the equity in the account would be $2,000 ($7,000 – $5,000). If the maintenance margin requirement is 25%, the investor would receive a margin call, as the equity in the account has fallen below the required level.
