- A margin call occurs when your investment account equity drops to a certain level and you owe money to your brokerage firm.
- Margin calls must be satisfied by depositing money into the account or by making up the difference you owe by selling assets or depositing other assets into the account.
- Using margin can increase potential return but also magnify your losses.
A margin call occurs when the value of your brokerage account falls below a certain level. This level is known as the margin requirement and means that the investor is required to deposit more money into the account, sell some of the investments or add more assets on margin if it is reached. .
“The best way to describe a margin call is that you owe money to your investing or brokerage platform,” says Robert Farrington, founder of The College Investor.
In the context of investing, margining is the practice of taking out a loan from the brokerage firm for the purpose of buying stocks and other assets. Margin can increase an investor’s purchasing power, allowing them to make larger investments and higher potential profits. “Margin is an incredible tool for providing investors with access to additional capital,” says Dr. Hans Boateng, Founder of The Investing Tutor. “It works wonders in a bull market. It becomes dangerous in a bear market if you don’t have savings on a margin call.”
How do margin calls work?
There are different types of margin calls and requirements depending on the type of account you have and the type of asset you can trade. Regardless of the type of account or what you invest in, once a margin call has occurred, you will need to bring the account down to a minimum through the previously mentioned methods. If the margin call is not satisfied quickly enough (usually 2-5 business days), your brokerage may sell your positions, which could result in a taxable event.
There are three main types of margin calls: maintenance margin calls, T-regulation calls and minimum capital calls. Each of these margin calls can be triggered for different reasons. Here’s a breakdown of each below.
Maintenance Margin Call: A maintenance margin call refers to the margin requirement to stay in a position. Once you have met the 50% initial margin requirement, the Financial Industry Regulatory Authority (FINRA) requires brokerages to set a maintenance requirement of at least 25% for the remainder of the trade and allow brokerages to be even more restrictive. This is sometimes known as “house need” and most brokerages set their maintenance needs at 30-40%.
Consider an example where you have invested $10,000 in ABC Company: If your brokerage sets the maintenance margin requirement at 25%, that means your account net worth should not fall below 2,500 $.
Remember that a margin account will include equity, which is the amount of money you have plus the amount that has been loaned to you. Therefore, the total account balance would need to be $7,500 to receive a margin call ($5,000 margin loan + $2,500 of remaining equity) because the value of the loan has not changed.
Here are some scenarios using a 25% maintenance margin requirement with $5,000 equity and $5,000 margin.
- If account value drops 10% to $9,000 = no maintenance margin call
- Equity = $4,000
- Margin balance = $5,000
- If account value drops 30% to $7,000 = maintenance margin call
- Equity = $2,000
- Margin balance = $5,000
- You must now add at least $500 to the account
- If account value drops 40% to $6,000 = maintenance margin call
- Equity = $1,000
- Margin balance = $5,000
- You must now add at least $1,500
Appeal by-law T: This type of call refers to the requirements needed to start a margin trade and can occur when an investor trades in a margin account without meeting the initial 50% minimum equity requirement. This is sometimes called Fed Call.
Minimum Equity Call: This is the lowest amount needed to open and maintain a margin account. This call – sometimes called a trade call – occurs when the account balance falls below $2,000 in equity. If you are classified as a model day trader, this requirement is $25,000.
How to Avoid Margin Calls
You are not required to have a margin account and you can easily avoid margin calls by trading only with cash. “The best way to avoid a margin call is to simply not use all of your margin limit,” says Farrington. Margin isn’t necessary to achieve strong, consistent returns over time, but for those who choose to use it, here are some steps you can take to avoid a margin call:
- Keep cash handy. One of the easiest ways to respond to a margin call is to add money to the account. However, if you don’t keep enough cash, it can be difficult.
- Stop-loss orders. Entering a stop loss order can help limit losses and, depending on the volatility that day, it could prevent the stock from falling enough to trigger a margin call.
- Stay informed. It is recommended that you do not check your investment account daily; however, this changes with a margin account due to the higher levels of risk. Investors can consider adding alerts if the price falls within a certain range.
- Use your margin limits wisely. Just because you have the ability to take out a large margin loan doesn’t mean you have to. If you use margin, consider using less than the maximum amount – this would give you a larger share of equity and a bigger cushion to avoid a margin call.
The bottom line
Using margin in an investment account can help increase gains, but it can also magnify losses. It’s important to make sure you’re managing your risk properly. “There’s really little reason to use margin,” adds Farrington. “It should only be used by experienced investors who have a specific plan and purpose for doing so. Maybe you’re investing today while waiting for that ACH deposit next week. Or maybe you’re running some options strategy. But you have to have a specific plan.”