Whether you’re a seasoned stock trader or only recently became interested in the market thanks to the Gamestop explosion, there’s always a lot to learn. The world of stock market trading is filled with lots of complicated mechanisms and confusing terms. They may sound like gibberish to a complete beginner. Think about some of the phrases thrown around on investing websites. Stop loss orders. After-hours trading. Call options. Margin calls. What do all these terms even mean? In this article, we’re going to tackle a single one of these questions: what is a margin call?
What is a Margin Call?
Before we get to a margin call, we need to talk about two other things: buying stocks on margin and the maintenance margin.
Buying stocks on margin is when an investor borrows money from a broker to invest in the market. This is also known as a margin account, and usually consists of both the investor’s money AND borrowed money from a broker. There are limits to how much borrowed money an investor can use, though. That limit is called the maintenance margin.
A margin call occurs when the value of an investor’s margin account falls below the broker’s required threshold. When that happens, the broker demands that an investor take steps to correct the ratios. The investor can then either deposit more of their own money or sell stocks in order to fund the account. They must being the account back up to the minimum value that is the “maintenance margin.”
A margin call typically occurs when an investor has lost a substantial amount of money on their trades in a short period of time. When a margin call happens, the investor must choose to either deposit more money into their brokerage account or sell some existing assets. Either way, they have to cover the call. Let’s dig a little deeper, and explain how margin calls can impact investors.
How A Margin Call Works
When buying on margin, an investor’s equity in the investment must be equal to the market value of the securities at a given time, minus the amount borrowed from the broker. A margin call is triggered when the investor’s equity falls below a certain percentage requirement, known as the maintenance margin.
If an investor cannot afford to pay the amount that is required to bring the value of a brokerage account back up to the account’s maintenance margin, they may be forced to sell stocks at the prevailing market rate to cover the shortfall. Both the New York Stock Exchange (NYSE) and the Financial Industry Regulatory Authority (FINRA) require that investors keep at least 25% of the total value of their securities as margin. However, some brokerage firms require a higher maintenance margin of 30% to 40%.
Doing The Math
There is a simple calculation to determine the exact amount that a particular stock would have to drop to trigger a margin call. It would happen when an account’s value equals the maintenance margin requirement (MMR). The formula for doing the calculation is:
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. They purchase 200 shares of a stock at a price of $50 per share. Let’s say that the broker’s maintenance margin requirement (MMR) is 30%.
Plugging in the formula, the account value is $5,000 (loan) divided by (1-0.30). That equals $7,142.86. That means if the value of the entire stock falls below that number, a margin call is triggered.
Let’s keep using our hypothetical $10,000 stock purchase ($5,000 of it borrowed). Let’s say the value of the stock falls to $30 a share. That leaves the entire account of 200 shares worth $6,000. That’s roughly $1,100 below the threshold, so a margin call would be triggered. The investor would need to find a way to make up the $1,100 shortfall in order to keep the maintenance margin at an acceptable level.
Investors can cover a margin call by adding additional cash or by selling some of the existing stock (even if forced to sell at a loss). If the investor doesn’t cover a margin call themselves, a broker can intervene. They may act to close out any open positions to bring the account back up to the minimum value required by securities regulators. Brokers can do this without the investor’s approval. Brokers have the right to sell any stock holdings to satisfy margin calls, without letting an individual investor know.
Real Margin Call Examples
Financial markets and banks around the world were rocked in early 2021. A a hedge fund known as Archegos Capital borrowed huge sums of money to invest in stocks. They were unable to cover the margin calls when the price of those stocks fell suddenly. The latest calculations put the total losses stemming from the collapse of Archegos Capital at $10 billion. Major banks like U.S.-based Morgan Stanley, Swiss banks UBS and Credit Suisse, and Japanese bank Nomura each lost hundreds of millions of dollars when Archegos Capital failed to cover its margin call. Credit Suisse actually lost the most, at $5.5 billion.
Archegos used borrowed money from banks all over the world to build huge positions in stocks. They notably invested in media companies like ViacomCBS and The Discovery Network. They were unable to pay back their lenders when the share prices of those stocks dropped without warning. Several margin calls were triggered at the same time. The banks eventually took control of Archegos’ accounts and liquidated the positions. However, the banks incurred heavy losses since the stock prices were down. This incident has led to calls for tighter regulations when it comes to lending money to invest in the stock market.
The Bottom Line
Investing on margin is not for everyone. It’s generally not recommended (or even allowed) for individual retail investors. Borrowing money (and paying interest on it) to invest in the stock market is a risky proposition, even for experienced investors. If a particular stock does not perform as expected, it could trigger a margin call. Suddenly, the investor needs to come up with additional cash or start selling stocks (potentially at a loss) to get a margin account back in good standing. And if they were borrowing money to invest in the first place, they may not have the resources ready for this expense.
This is not a situation any investor wants to find themselves in. Failure to act can result in the brokerage account being seized. Your broker can take over the entire account in an attempt to fix things. The safest bet is to only invest money that you already have. Don’t invest with borrowed money. And ultimately, don’t risk money in the stock market that you can’t afford to lose. There are plenty of safer ways to invest that don’t include trying to pick the winning ticket in the stock market lottery. Taking on debt to buy stocks on margin can lead to a collapsing house of cards.
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