Margin call: What it is and how to avoid one

A margin call occurs when the value of securities in a brokerage account falls below a certain level, known as the maintenance margin, requiring the account holder to deposit additional cash or securities to meet the margin requirements. Margin calls only happen in accounts that have borrowed money to purchase securities, and they usually occur in fast-declining markets.

Here are some other things to keep in mind about margin calls and how to avoid them.

What is a margin call?

A margin call may sound like the sort of thing that only happens to big players on Wall Street, but it can also happen to small investors who have purchased securities on margin, or using borrowed money. Here’s how it works.

If you’ve opened a margin account with an online broker, it means that you’ll be able to purchase securities such as stocks, bonds and exchange-traded funds (ETFs) using a combination of your own money and money the broker has lent to you. The borrowed money is known as margin. This will allow you to trade more than you otherwise would be able to and will magnify your returns, either positively or negatively.

One caveat to buying on margin is that you’ll also have a maintenance margin requirement, which requires you to maintain a certain percentage of equity in your account. When your portfolio falls below the maintenance margin, usually due to declining security prices, you’ll be hit with a margin call from your broker.

Once you’ve received a margin call, you have a few options:

1. Deposit additional cash into your account up to the maintenance margin level
2. Transfer additional securities into your account up to the maintenance margin level
3. Sell securities (possibly at depressed prices) to make up the shortfall

If you aren’t able to meet the margin call fast enough to satisfy your broker, it may be able to sell securities without your permission in order to make up for the shortfall. You will typically have two to five days to respond to a margin call, but it may be less during volatile market environments.

When do margin calls happen?

Margin calls can occur at any time, but are more likely to happen during periods of high market volatility. Here’s what triggers a margin call:

• A security you hold declines and takes the value of your margin account below the required maintenance margin. If you’re short a security (betting against it), a margin call can be triggered if it appreciates, or moves against you.
• You’re then required to deposit additional capital into your account up to the maintenance margin level. The funds can be cash or additional securities.
• If you don’t make a deposit, your broker may require you to sell something in order to meet the margin call.

How to avoid a margin call

The easiest way to avoid a margin call is to not have a margin account in the first place. Unless you’re a professional trader, buying securities on margin is just not something that’s necessary to earn decent returns over time. But if you do own a margin account, here are a few things you can do to avoid a margin call.

• Have extra cash on hand. Having extra cash that’s available to be deposited in your account should help you if a margin call comes. Depositing additional funds is one way to get you in compliance with margin requirements.
• Diversify to limit volatility. Diversification should help limit the chances of an extreme decline that might trigger a margin call quickly. Conversely, being overly concentrated in volatile assets could leave you vulnerable to sharp declines that could trigger a margin call.
• Track your account closely. While most people are better off not looking at their portfolios every day, if you have a significant margin balance you’re going to want to track it daily. This will help you stay aware of where your portfolio stands and whether you’re close to the maintenance margin level.

Margin call example: How to calculate

Let’s say you’ve deposited $10,000 into your account and borrowed another $10,000 on margin from your broker. You decide to take your $20,000 and invest it in 200 shares of XYZ company, trading for $100 a share. Your maintenance margin is 30 percent.

In this example, if the market value of the account falls below $14,285.71, you’ll be at risk of a margin call. So if the stock price of XYZ falls to $71.42 or lower, you’ll face a margin call.

Let’s say Company XYZ reports disappointing earnings results and the stock falls to $60 not long after you bought it. The value of the account is now $12,000, or 200 shares at $60 per share, and you’re $1,600 short of the 30 percent margin requirement. You have a few options.

• Deposit $1,600 of cash into the account to meet the margin call.
•  Deposit marginable securities. The amount of securities you’ll need to deposit depends on the deposited securities’ maintenance requirement. Assuming it’s also 30 percent, you’ll need to deposit $2,285.71 of securities to meet the margin call ($1,600/1-0.30).
• Sell $5,333.33 of XYZ stock to pay down the margin loan and boost your account equity to the 30 percent requirement.

It should be noted that these are the minimum requirements to bring you back into compliance with the maintenance margin. If the stock continues to decline, you’ll need to put up additional equity.

It’s important to remember that the broker will be paid back in full for its loan and any losses are entirely yours. In this example, you deposited $10,000 of your own money and borrowed another $10,000 on margin. The account value declined to $12,000, leaving you with just $2,000 in equity and a decline of 80 percent, despite the stock only falling 40 percent.

In reality, your broker may not give you much of a warning about a margin call and could even sell securities in your account without your permission or with no regard to tax strategies. Margin calls are often triggered during extreme market volatility and brokers may try to reduce their risk by calling in margin loans with little notice.

Bottom line

Buying securities on margin is not a good idea for most investors who are saving for a long-term goal such as retirement. A margin call will force you to boost your account equity either by adding additional cash and securities, or by selling existing holdings. Because margin calls often occur during periods of extreme volatility, you may be forced to sell securities at depressed prices.

Editorial Disclaimer: All investors are advised to conduct their own independent research into investment strategies before making an investment decision. In addition, investors are advised that past investment product performance is no guarantee of future price appreciation.