A margin call is a demand from a broker to deposit additional funds into a margin account. A margin account is a type of brokerage account that allows investors to borrow money from their broker to purchase securities. The amount of money that an investor can borrow is limited by the broker's margin requirements.
The margin requirement is the percentage of the purchase price of a security that must be paid for with the investor's own money. For example, if the margin requirement is 50%, then the investor must pay for 50% of the purchase price with their own money and can borrow the remaining 50% from their broker.
The value of the securities in a margin account is constantly changing. If the value of the securities falls below a certain level, known as the maintenance margin, the broker will issue a margin call. The maintenance margin is typically lower than the initial margin requirement.
For example, if the initial margin requirement is 50% and the maintenance margin is 30%, then the investor must deposit additional funds into their account if the value of the securities falls below 30% of the purchase price.
If an investor does not meet a margin call, the broker may sell) some of the securities in the account to cover the margin loan. This is known as a forced liquidation.
Margin calls are a risk of margin trading. Investors who use margin should be aware of the risks and should have a plan for how they will meet margin calls.
Here are some examples of how margin calls can occur:
- An investor buys 100 shares of a stock for $100 per share, using a margin requirement of 50%. The investor pays $5,000 for the stock with their own money and borrows $5,000 from their broker.
- The stock price falls to $50 per share. The value of the investor's stock is now $5,000.
- The maintenance margin is 30%. The value of the investor's stock must now be at least $3,000 (30% of the purchase price).
- The investor must deposit an additional $2,000 into their account to meet the maintenance margin requirement.
If the investor does not meet the margin call, the broker may sell some of the shares of stock to cover the margin loan.
Risks Of Margin
Buying securities on margin involves borrowing money from a broker to purchase securities. This can magnify both gains and losses. While margin trading can be a profitable strategy, it also carries a number of risks:
- Amplified losses: If the value of the securities you buy on margin declines, your losses will be magnified. For example, if you buy $10,000 worth of stock on margin with a 50% margin requirement, you will only need to put up $5,000 of your own money. If the stock price falls by 50%, you will lose your entire $5,000 investment. However, if you had bought the stock without using margin, you would only lose $5,000.
- Margin calls: If the value of the securities in your margin account falls below a certain level, known as the maintenance margin, your broker will issue a margin call. This is a demand to deposit additional funds into your account to bring the value of your securities back up to the maintenance margin level. If you do not meet a margin call, your broker may sell some of the securities in your account to cover the margin loan. This can result in forced liquidation of your positions, even if you believe they have long-term potential.
- Higher interest costs: Margin loans typically have higher interest rates than other types of loans. This is because they are considered to be riskier loans. The higher interest costs can eat into your profits, even if your investments are successful.
- Increased stress: Margin trading can be a stressful experience. The risk of losing more money than you invested can be a major source of anxiety. This stress can lead to poor investment decisions.
Margin trading is not suitable for all investors. It is important to carefully consider the risks before using margin.
In addition to the risks listed above, margin trading can also lead to:
- Overtrading: Margin trading can make it easier for investors to overtrade. This is because investors can buy more securities than they could if they were using only their own money. Overtrading can lead to increased losses.
- Poor investment decisions: The pressure to meet margin calls can lead investors to make poor investment decisions. For example, an investor may be tempted to sell a security that they believe has long-term potential in order to meet a margin call.
- Addiction: Margin trading can be addictive. The thrill of making quick profits can lead investors to become addicted to margin trading. This can lead to reckless investment behavior and significant losses.