What Is a Margin Call and How Do You Avoid It?

Say you borrowed money from a broker to buy securities in a volatile market, and the securities’ market value drops below a certain level known as the maintenance margin. Then, you receive a call from your broker to deposit additional funds or securities into your account so that it meets the minimum maintenance margin requirement. 

In short, that call is a margin call.

Understanding Margin Trading

Understanding the margin call definition we’ve given above will be much easier once we cover all the related terms: margin in general and maintenance margin in particular, margin account, margin loan, and margin trading. We’ll go over them one by one.

First of all, the word “margin” has two distinct meanings in business and finance. When talking about margins in business, we usually talk about profit margins - that is, the sum you get when you subtract the cost of goods sold from the total sum earned from selling those goods.

In finance, however, margin is simply the equity you have in your margin account, which is a type of brokerage account you open when you want to borrow money from a broker to purchase a financial product such as futures or options. 

The funds you borrow are the margin loan, while the act of buying securities with it is called “buying on margin” or “margin trading.” The securities you buy act as collateral for your margin loan.

After you complete your purchase, your equity in the margin account must not drop below a certain level, known as the maintenance margin. According to the Financial Industry Regulatory Authority, that level is currently set at 25% of the total value of the securities in your margin account, although some brokerages may impose a higher maintenance margin. 

This is where we again approach the term “margin call.” A portfolio falling under the maintenance margin is precisely what triggers a margin call. If it happens, you must deposit money or securities to achieve the account equity and bring your account back into good standing.

How Margin Calls Work

So, we’ve established that your account value consists of the margin and the funds you’ve borrowed from the broker on margin. This increases your earnings if everything goes well, but also your losses if the market declines.

If the latter happens, you’ll have a few options, which we’ll discuss later in this article. But first, let’s take a look at the cause of the margin call.

What Causes a Margin Call?

As mentioned, a margin call occurs when the value of securities in a margin account falls below the broker’s maintenance requirements. 

It usually happens when the market value of the securities declines. To understand better how this works, let’s take a look at a margin call example. 

For instance, you found the right number of stocks to meet your needs, deposited $10,000 into your account, and borrowed another $10,000 from a brokerage firm, totaling $20,000. Next, you bought 200 shares for the stock price of $100 each. Your account value is now $20,000. The maintenance margin of the broker you’ve borrowed $10,000 from is, for example, 30%.

Soon after you bought securities, their market value drops to $60 per share, which equals $12,000. Since your minimum account value is $14,285.71 (This is calculated using the following formula: Margin loan value / (1 - maintenance margin)), you must now secure additional capital to meet the maintenance margin requirement. 

Brokers Don’t Call Every Time the Account Value Drops

Now, let’s see what happens during a margin call. 

If the value of your securities in your margin account falls below a certain level set by your brokerage firm, it will issue a margin call, requesting that you add cash or securities to your account. If you can’t meet this demand, your brokerage may sell securities of yours to bring your account up to the maintenance margin requirement.

Note that you might not receive margin calls every time your margin account drops. Even so, the brokerage firm will sell your securities to restore the balance. So, carefully read the terms and conditions when searching for an online stock broker. And remember that the assets sold during margin calls usually don’t produce positive financial results.

How To Avoid a Margin Call

There are several ways you can reduce the risk of receiving a margin call from your broker:

• Buy assets boasting high earning potential. If you invest on margin, this strategy is usually the best.
• Limit volatility diversification. By resorting to this option, you limit the odds of extreme declines in the value of your securities portfolio.
• Keep a close eye on your account. Regularly monitor the value of your securities and your loan balance. It will help you stay on top of any changes and take the necessary action to avoid a margin call.
• Secure extra cash, even at the expense of buying additional securities. If you think there’s a chance you might get a margin call, it’s always a good idea to have some extra cash available. If you get a margin call, you can immediately deposit the funds into your account and avoid any negative consequences.
• Set your minimum maintenance margin higher than your brokerage requires. By transferring funds into your account when the margin reaches the limit you’ve established, you can avoid a margin call, meaning you don’t risk significant losses when the broker sells your securities.
• Make regular debt repayments. Although you enjoy flexibility when it comes to repayments on your margin loan, you should repay at least a portion of your debt each month. That way, you keep the interest under control and the margin account at the level your broker requires. 

How To Restore Your Margin Account

Prevention is better than cure, but sometimes you won’t be able to avoid a margin call. 

If you do receive a call, you can do any of the following:

• Deposit more cash into your account
• Sell securities at lower prices to make up for the shortfall
• Transfer additional capital into your account after buying securities

Note that you won’t have much time to act: Brokers usually give investors between two and five days to restore the margin account following a margin call. 

Final Word

Knowing what happens during a margin call can help you avoid making costly mistakes. Remember to keep a close eye on your account, limit exposure to volatile markets, and pay down your monthly loan. With these tips, you’ll be well on your way to success in online stock trading.