What Is a Margin Call?
A margin call occurs when the value of an investor's margin account falls below the broker's required amount. An investor's margin account contains securities bought with borrowed money (typically a combination of the investor's own money and money borrowed from the investor's broker). A margin call refers specifically to a broker's demand that an investor deposit additional money or securities into the account so that it is brought up to the minimum value, known as the maintenance margin.
A margin call is usually an indicator that one or more of the securities held in the margin account has decreased in value. When a margin call occurs, the investor must choose to either deposit more money in the account or sell some of the assets held in their account.
- A margin call occurs when a margin account runs low on funds, usually because of a losing trade.
- Margin calls are demands for additional capital or securities to bring a margin account up to the minimum maintenance margin.
- Brokers may force traders to sell assets, regardless of the market price, to meet the margin call if the trader doesn't deposit funds.
Understanding Margin Calls
When an investor pays to buy and sell securities using a combination of their own funds and money borrowed from a broker, it is called buying on margin. An investor's equity in the investment is equal to the market value of the securities, minus the amount of the borrowed funds from their broker. A margin call is triggered when the investor's equity, as a percentage of the total market value of securities, falls below a certain percentage requirement (called the maintenance margin). If the investor cannot afford to pay the amount that is required to bring the value of their portfolio up to the account's maintenance margin, the broker may be forced to liquidate securities in the account at the market.
Both the New York Stock Exchange (NYSE) and the Financial Industry Regulatory Authority (FINRA)–the regulatory body for the majority of securities firms operating in the United States– requires that investors keep at least 25% of the total value of their securities as margin. Some brokerage firms require a higher maintenance requirement—as much as 30% to 40%.
Obviously, the figures and prices with margin calls depend on the percent of the margin maintenance and the equities involved.
In some instances, an investor can calculate the exact price that a stock has to drop to in order to trigger a margin call. Basically, it will occur when the account value, or account equity, equals the maintenance margin requirement (MMR). The formula would be expressed as:
Account Value = (Margin Loan) / (1 – MMR)
For example, suppose an investor opens a margin account with $5,000 of their own money and $5,000 borrowed from their brokerage firm as a margin loan. They purchase 200 shares of a stock on margin at a price of $50. (Under Regulation T, a provision that governs the amount of credit that brokerage firms and dealers may extend to customers for the purchase of securities, an investor can borrow up to 50% of the purchase price). Assume that this investor's broker's maintenance margin requirement is 30%.
The investor's account has $10,000 worth of stock in it. In this example, a margin call will be triggered when the account value falls below $7,142.86 (i.e. margin loan of $5,000 / (1 – 0.30), which equates to a stock price of $35.71 per share.
Using the example above, let's say the price of this investor's stock falls from $50 to $35. Their account is now worth $7,000, which triggers a margin call of $100.
In this scenario, the investor has one of three choices to rectify their margin deficiency of $100:
- Deposit $100 cash in the margin account, or
- Deposit marginable securities worth $142.86 in their margin account, which will bring their account value back up to $7,142.86, or
- Liquidate stock worth $333.33, using the proceeds to reduce the margin loan; at the current market price of $35, this works out to 9.52 shares, rounded off to 10 shares.
If a margin call is not met, a broker may close out any open positions to bring the account back up to the minimum value. They may be able to do this without the investor's approval. This effectively means that the broker has the right to sell any stock holdings, in the requisite amounts, without letting the investor know. Furthermore, the broker may also charge an investor a commission on these transaction(s). This investor is held responsible for any losses sustained during this process.
The best way for an investor to avoid margin calls is to use protective stop orders to limit losses from any equity positions, in addition to keeping adequate cash and securities in the account.
Real World Example of a Margin Call
Suppose an investor buys $100,000 of Apple Inc. using $50,000 of his own funds. The investor borrows the remaining $50,000 from their broker. The investor's broker has a maintenance margin of 25%. At the time of purchase, the investor's equity as a percentage is 50%. The investor's equity is calculated using this formula: Investor's Equity As Percentage = (Market Value of Securities – Borrowed Funds) / Market Value of Securities. So, in our example: ($100,000 – $50,000) / ($100,000) = 50%.
This is above the 25% maintenance margin. Suppose that two weeks later, the value of the purchased securities falls to $60,000. This results in the investor's equity falling to $10,000. (The market value of $60,000 minus the borrowed funds of $50,000, or 16.67%: $60,000 – $50,000) / ($60,000.)
This is now below the maintenance margin of 25%. The broker makes a margin call and requires the investor to deposit at least $5,000 to meet the maintenance margin.
The broker requires the investor to deposit $5,000 because the amount required to meet the maintenance margin is calculated as follows:
Amount to Meet Minimum Maintenance Margin = (Market Value of Securities x Maintenance Margin) – Investor's Equity
So, the investor needs at least $15,000 of equity–the market value of securities of $60,000 times the 25% maintenance margin–in their account to be eligible for margin. But they only have $10,000 in investor's equity, resulting in a $5,000 deficiency: ($60,000 x 25%) – $10,000.