Leverage holds significant potential, enabling borrowers to undertake larger projects than they would typically manage and possibly yielding greater returns on their initial investment. However, employing leverage, such as purchasing stocks on margin, also introduces the possibility of increased losses if the venture falls short of expectations—similar to facing a margin call.
What Is a Margin Call?
A margin call takes place when the proportion of an investor’s equity in a margin account dips below the broker’s required threshold. The margin account holds securities purchased with a mix of the investor’s own funds and money borrowed from their broker.
Margin calls specifically denote a broker’s request for the investor to add more money or securities to the account, raising the value of the investor’s equity (and the account value) to meet the minimum maintenance requirement.
Typically, a margin call indicates that the securities within the margin account have lost value. When faced with a margin call, investors must decide whether to deposit additional funds or marginable securities into the account or liquidate some of the assets held in their account.
What Triggers a Margin Call?
A margin call is triggered when an investor’s equity in a margin account falls below the broker’s required maintenance margin. Several factors can contribute to a margin call:
- Decline in the value of securities: If the value of the securities held in the margin account decreases significantly, the investor’s equity in the account can drop below the maintenance margin requirement. This decline can result from market fluctuations or poor performance of the underlying assets.
- Increase in margin requirements: Brokers may increase the maintenance margin requirements for specific securities or the entire portfolio, often in response to heightened market volatility or changes in regulatory rules. If the new requirements are higher than the investor’s current equity, a margin call will be triggered.
- Excessive use of leverage: Using leverage to purchase securities increases the investor’s buying power but also amplifies the potential for losses. If an investor over-leverages their account, they might face a margin call when the value of their investments declines.
- Margin interest charges: Interest is charged on the borrowed funds used to purchase securities on margin. If these interest charges accumulate and reduce the investor’s account value below the maintenance margin requirement, a margin call may be triggered.
- Forced liquidation: In some cases, a broker might be forced to liquidate an investor’s position due to regulatory requirements or internal risk management policies. This forced liquidation can lead to a margin call if the investor’s remaining equity falls below the maintenance margin.
To avoid margin calls, investors should closely monitor their accounts, maintain a diversified portfolio, and use leverage judiciously.
Example of a Margin Call
Here’s an example of how a change in the value of a margin account decreases an investor’s equity to a level where a broker must issue a margin call.
| Security Value | Loan Amount | Equity ($) | Equity (%) | |
|---|---|---|---|---|
| Security bought for $20,000 (half on margin) | $20,000 | $10,000 | Investor Equity = $10,000 | Investor Equity = 50% |
| Value drops to $14,000 | $14,000 | $10,000 | $4,000 | Investor Equity = 28% |
| Maintenance requirement of broker | $14,000 | $4,200 | 30% | |
| Resulting margin call | $200 |
How to Cover a Margin Call
Here are 2 simple ways of how investor could meet he/she margin call:
- Deposit cash: Investor could simply deposit $200 into her account.
- Sell shares of stock: Sell other securities to obtain the needed cash.
Ways to Avoid Margin Calls
Margin calls can be a distressing event with significant financial repercussions. Your brokerage firm might liquidate securities you possess—without informing you and regardless of tax implications—to boost your account’s equity. Thus, it’s advisable to follow these recommendations to reduce the likelihood of facing a margin call:
- Prepare for volatility: Leave a considerable cash cushion in your account that protects you from a sudden drop in the value of your loan collateral.
- Set a personal trigger point: Keep additional liquid resources at the ready in case you need to add money or securities to your margin account.
- Monitor your account daily: Consider setting up alerts to notify you when the value of your stock declines significantly.
- Do Not Used Borrowed Funds: To avoid margin calls, one approach is to refrain from using borrowed funds for investment purposes. By only investing with your own money, you eliminate the need for a margin account and the associated risks of margin calls. This strategy ensures that your investments are solely funded by your personal capital, reducing the chances of facing unexpected losses or having to meet margin requirements.
- Use Less Than the Maximum Margin: To reduce the risk of a margin call, consider using less than the maximum margin allowed by your brokerage. By employing a lower level of leverage, you provide yourself with a larger buffer in case the value of your investments declines. This approach helps protect your account from falling below the maintenance margin requirement, thereby lowering the likelihood of facing a margin call. Additionally, using less leverage enables you to maintain better control over your investments and manage risk more effectively.
- Use Leveraged ETFs:Using Leveraged Exchange-Traded Funds (ETFs) can be an alternative approach to avoid margin calls while still benefiting from the potential gains of leveraged investments. Leveraged ETFs are financial products that magnify the performance of an underlying index, sector, or asset by using financial instruments such as derivatives. By investing in leveraged ETFs, you can gain exposure to leveraged returns without borrowing money from your broker, thereby avoiding the need for a margin account. This way, you can minimize the risk of a margin call since you’re not directly using borrowed funds to invest. However, it’s crucial to understand that leveraged ETFs come with their own set of risks and are typically designed for short-term trading strategies. These products can be subject to high levels of volatility, and their performance may not precisely track the intended multiple of the underlying index or asset over longer periods. As a result, leveraged ETFs may not be suitable for all investors, especially those with a long-term investment horizon or a low risk tolerance.
Conclusion
In conclusion, margin calls can be a stressful and financially impactful event for investors who use borrowed funds in their investment strategies. To minimize the risk of facing margin calls, investors should consider avoiding the use of borrowed funds, utilizing less than the maximum margin allowed, and exploring alternative leveraged investment options such as leveraged ETFs. By employing these strategies and maintaining a disciplined approach to risk management, investors can better navigate the complexities of leveraged investing and safeguard their financial well-being. It is essential for investors to understand the risks associated with margin trading and to monitor their accounts closely to ensure they maintain a healthy equity balance and avoid unexpected losses.
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