Margin Call

It is an intimation that traders receive from their brokers.

Margin Call is an intimation that traders receive from their brokers. This notification is served to the customers whose margin accounts have fallen below the limit set by brokers for the customers. The limit is called the maintenance margin requirement (MMR).

Margin Call

These limits are generally set around a minimum of 25%. It complies with the Federal Reserve's Regulation T. Regulation T states that investors can take a margin loan from the brokerage firm if they want to purchase securities. 

Firms can extend credit up to 50% of the total value of the investment. Some brokers may also set the maintenance margin requirement as 30% or 40%. The limit depends on brokers' regulations and the investor's equity in the account.

They are triggered only for margin accounts. Margin accounts enable investors to deal with riskier investments that have the potential to provide huge returns. Margin accounts balance comprises a summation of the investor's equity and borrowed money from their broker/dealer.

Staying above the MMR limit gets tricky as the fund borrowed is always in a fixed amount. However, the values of securities bought by leveraging the broker's fund tend to fluctuate. Along with it, the maintenance margin also changes.

Having a margin call triggered is a serious issue. Therefore, brokers usually give a few days to the investors to meet the MMR. However, Investors are not entitled to this period, and brokers can sell investors' security to recover the loss incurred anytime as per their convenience.

Understanding the concept

Balance

A margin call is a way to state the broker's demand for additional funds to be deposited in the margin account by the customer. They are triggered in margin accounts held by an investor with his broker-dealer. 

It is triggered when the margin account's balance drops below a limit agreed between the broker and his client. Margin accounts are a combination of investors' equity and borrowed funds from their brokers.

It lets investors invest in stocks they might have opted out of otherwise. The amount borrowed from the broker remains the same. However, the investor's equity keeps changing since securities are bought under a margin account.

Earlier, the intimation was served to the customers via phone. Texts and emails have become prevalent only now, which is why this notification is called a 'Margin Call.'

Usually, the New York Stock Exchange (NYSE) and the Financial Industry Regulatory Authority (FINRA) impose that traders keep 25% of their equity in the margin account as Margin at all times. Some firms charge 30% - 40% as their maintenance margin requirement.

Investment firms tend to set a higher maintenance margin requirement due to volatile investments and the overall balance in the account. Brokers tend to set a margin call over a certain limit to hold the remaining investor's equity as collateral for the funds lent.

Margin investing in its entirety is a risky business. It is not for the ones who are looking to save for their retirement. The volatility of the market can result in extreme losses. However, it becomes necessary for a few reasons.

Investors sometimes require additional funds to go ahead with an investment. Margin trading enables your broker to be a lender to you. Moreover, techniques like short selling a stock require a margin account as securities sold are bought with borrowed money.

credit score

Once this call is triggered, investment firms generally give a span of a few days to the investor to bring the account balance back to the limit via different alternatives. However, brokers can liquidate the securities in the account without informing the investor to maintain the MMR.

It can be covered through 3 different alternatives: -

  •  Depositing cash is required to cover the gap between the current balance and the account's MMR.
  •  Depositing amount in the form of securities to meet the account's MMR.
  • Liquidating the stocks already present in the account to meet the limit.

Margin trading can be assumed to be a short-term loan. The broker lends the money and charges a periodic interest rate. Brokerage firms report to credit agencies; therefore, defaulting on margin account transactions can affect one's credit score.

Liquidating stocks immediately due to a penalty imposed can be a serious loss on the incurring proposition. The broker charges a fine alongside the commission on transactions to maintain the account's balance.

penalty

Type

There are three types: 

  1. Federal Calls- These are called 'initial calls'; these occur when an investor fails to meet the MMR for a purchase.
  2. Exchange Calls- these occur when the account's equity falls below a certain percentage compared to the account's value. 
  3. Maintenance Calls are called' house' or 'brokerage' calls. They also occur like exchange calls when the account's equity falls below a particular percentage of its value. 

An example

phone call

Investors can determine the exact level to which stock needs to drop for a margin call to be triggered. It occurs the moment an investor's equity is equal to the maintenance margin requirement (MMR). It can be arithmetically expressed as: - 

Account Equity = [Margin loan(Borrowed Fund)] / (1-MMR)

For Instance, an investor wants to trade in marginal securities. The price of each share is $100. For this, he opens a marginal account. To buy 100 shares, he deposits $5,000 in the marginal account and borrows $5,000 from his broker-dealer (under Regulation T). 

Marginal securities are risky but can end up providing high returns to the investor. For example, suppose the investment firm sets its maintenance margin requirement as 30%. Since MMR is 30%, the exact investment amount can be determined, which will trigger the call. 

By using the formula for account equity, the moment the account value falls below $7,142.86 [$7,142.86 = $5,000 / (1 - 0.30)] will trigger it.

It implies that it will be triggered when the share value decreases from $100 to $71.42. If the stock price further drops to $70. The account value will be worth $7,000, and the account's equity will remain at $2,000. 

The MMR has since been set up at 30%. Now, if the account value falls to $7,000 from $10,000. The account's equity falls from $5,000 to $2,000. Since the investor's equity is not even 30% (i.e., $2,100) of the total account value. Therefore, it will be triggered by $100.  

Tag

Other formulas: -

Account Equity in % = (value of security – margin loan) / value of security

= ($10,000 - $5,000) / $10,000 = 50%

Amount to cover in MMR = (value of securities*Maintenance Margin) – Account Equity

= $7,000 * 30% - $2000 = $100

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How to Cover a Margin Call?

cover

The main aim of covering a call is to deposit sufficient money according to the maintenance margin requirement (MMR). A margin account is a trading account, and investors have several ways to meet the gap.

  • The amount required for meeting the gap can be deposited in cash. This is the most convenient and most used alternative out of the lot. For Instance, in the example stated above, the investor can deposit $100 in the account to meet the MMR.
  • Another way is to deposit marginal securities instead of cash. Marginal securities deposited are of more value than the cash required to meet the gap. However, securities value fluctuates.

In the above example, instead of $100 in cash, the investor can pay $142.86 worth of marginal securities. So, if the securities' price falls, the account can still stay at par with the MMR. 

Marginal securities are speculative and do not have a fixed price. So as a matter of safety for the broker's fund, in the above example, only 70% of the securities can be used to meet the marginal deficiency (as 30% is the MMR). 

time to sell

  • The third way is to liquidate stocks. The stocks that need to be liquidated can be determined by the formula of (the amount to cover in MMR / MMR) / new share price. So, 4.76 [(100 / 0.3) / $70] rounded off to 5 stocks worth $333.33 need to be liquidated.

Broker's Response

Broker's Response

If the margin call is met, the situation is resolved instantly. If it is not met or the investor refuses to respond, brokers have full autonomy in dealing with the situation. The broker's funds are at risk if the investor fails to maintain the MMR.

The broker has the right to liquidate or sell off any securities purchased by the investor to terminate the gap. This provision is not restricted to liquidating just the securities in the marginal account but any account that an investor has with a particular brokerage firm.

Meeting the maintenance margin requirement becomes the top priority. Brokers can sell any securities without thinking about the repercussions that investors can face due to this. Moreover, brokers will charge commissions on transactions carried out while liquidating the assets.

If forced sales have not compensated for the amount required, investors must provide the remaining amount in cash to the broker. Otherwise, brokers can adopt legal collection methods like filing debt-collection lawsuits.

Brokers provide a week or so to the investors to maintain their margin accounts. 

However, providing this time to the investors is not mandatory, and brokers can begin liquidation procedures according to the amount to be recovered immediately without informing the investors.

sold out

Defaulting and receiving margin calls time and again is a big red flag. Brokerage firms are connected with credit agencies. Several related defaults can have serious implications on an investor's credit score. It can also result in the termination of the account. 

How to avoid a margin call?

money

Margin trading or shorting stocks is used by seasoned investors and requires a lot of knowledge about the stock market. 

Novice investors investing for long-term returns generally stay away from margin trading. Still, a few things can be kept in mind to avoid a few mistakes. 

  •  Excessive cash at hand - depositing cash is the most convenient way to meet a margin call. Therefore, it is very important to have excessive cash for investors who are trading by leveraging their broker's money. 
    This provides them the flexibility required to cover the gap suddenly. Other alternatives require investors to pay more than the amount needed as securities do not have a fixed value. 
  • Diversification in asset classes - diversification among asset classes puts an investor in a situation that provides him better odds against the dynamic nature of the market if the sources are scattered all over different industries. 
    Then a market crash in one of the industries will not be as detrimental for the investor as it could have been. This will protect the investor from huge losses. The divide between borrowed funds and investors' equity will also be stable.
  • Sharply observing margin accounts - investors investing to save for their retirement or to reap the benefits of investing after years do not have to check their investments' status every day as the market sentiment does not change drastically.
    However, if an investor has a margin account, he must keep a close check on his balance daily to prevent the investor's equity from falling below the MMR. Otherwise, investors will have to face serious financial implications.
  • Use Stop-Loss Orders or Price Alerts - investors can choose to be notified about price alerts from their brokerage firm to keep a check on their margin account's balance. Investors can also always use tools like stop-loss orders to stay over the MMR.

terms of service

It is also important for investors to discuss the terms and conditions imposed by their brokerage for a margin call. However, authorities have framed general laws for it. Nevertheless, they are not rigid and, under a few conditions, can be adjusted by the firms according to their preferences.

Bottom Line

Conclusion

Margin trading is developed for risky transactions in general. Seasoned investors practice margin trading as they are willing to take a huge risk to earn an exorbitant investment return quickly. Novice investors usually stay away from margin trading.

Through margin accounts, investors can carry out risky transactions due to the financial backing they get from their broker-dealers in the form of margin loans (fixed amounts lent by the broker to the investor). Margin call gets triggered if the investor does not maintain MMR.

It is complicated to handle a margin account and requires the regular involvement of the investor. Investors need to compute the interest rate and other costs charged on margin accounts before they begin to trade in marginable securities and earn a profit worth the risk.

They can result in investors incurring huge losses. Therefore, investors should be crystal clear regarding their financial goals and have some experience in the stock market before they enter into margin trading.

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Researched and authored by Priyansh Singal | LinkedIn

Reviewed and edited by Tanay Gehi | Linkedin

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