Margin accounts are a special type of brokerage account where the broker extends a line of credit to the investor that can be used to increase the number of securities they’ll purchase. However, since these funds are essentially a loan, the brokerage needs some assurances that the investor can pay them back.
Hence, when the market declines and the investor’s securities lose value, the brokerage will notify investors that their account value is too low with a margin call.
How Does a Margin Call Work?
When an investor opens a margin account with a brokerage, they will have the ability to trade more money than what they’ve personally contributed. For example, an investor with $15,000 in their margin account may be granted an additional $15,000 to trade. This allows them to buy $30,000 worth of stocks, bonds, ETFs (exchange-traded funds), and any other securities they desire.
Of course, margin accounts aren’t free money. Any margin that’s borrowed must eventually be paid back with interest. However, another important agreement that investors must adhere to is what’s called a maintenance margin requirement. This is the minimum amount of equity that the accountholder must maintain at all times in their margin account.
As the markets fluctuate, the accountholder’s investments may gain or lose value. In the unfortunate situation that they lose too much value and go below the maintenance requirement, the brokerage will notify the account holder of the shortage with a margin call. This is an official demand that the accountholder must shore up the difference by doing one of the following:
- Depositing more cash into their account
- Transfer additional securities from another brokerage account
- Sell their securities
A margin call cannot be ignored and the accountholder must take action ASAP. They will have a short amount of time (generally 2 to 5 days) to get their account back up to maintenance level or face repercussions.
Example of a Margin Call
Let’s revisit the example where an investor has contributed $15,000 and is borrowing another $15,000 on margin from the brokerage. Additionally, we’ll assume the maintenance requirement is 30 percent.
Suppose the investor used this $30,000 to buy 200 shares of a company whose stock price is $150. However, after six months, those shares drop to $100 each. This drags the entire account balance down to $20,000.
In this circumstance, the account holder still owes the broker $15,000. This means only the investor only really holds $5,000 of equity (or 25 percent).
Since this equity is below the maintenance requirement of 30 percent, the broker will issue a margin call for the difference of 5 percent. That means they would have to transfer $1,000 into the account as soon as possible.
Why Do Investors Use Margin Accounts?
Margin accounts are essentially a way for an investor to amplify their potential gains. For instance, if the stock held by the investor in our previous example had increased to $200 rather than dropping in value, then their 200 shares would now be worth $40,000. That’s a capital gain of $10,000 instead of the $5,000 they would have made with just their contribution alone.
However, the danger with margin calls is that they can also amplify losses too. In theory, if the stock was to drop in value to $0, then the investor would not only lose their initial $15,000, but they would also lose the $15,000 that they borrowed from the broker. Hence, margin calls are put in place as a way to help prevent this from happening (i.e., before the losses become too severe).
What Happens If You Don't Meet a Margin Call?
In the event that an investor can’t fulfill their margin call obligation, the broker may be forced to liquidate the investor’s assets - even without their consent. This is undesirable for the investor because the assets will most likely be sold at a loss. Since the broker must be paid back no matter what, those losses will be reflected in the investor’s equity.
How to Avoid a Margin Call
Despite fluctuations in the market, investors can take steps to reduce their chances of receiving a margin call. The following are a few commonly used strategies.
- Diversify your portfolio. Holding just a handful of stocks is risky. Add some variety to your portfolio and it will lower the chances that it will lose value.
- Don't use all of your margin account balance. Just because a broker may let you borrow an amount equal to 100 percent of your equity, this doesn’t mean that you have to. Borrowing a smaller portion and keeping the rest as cash will help strengthen its ability to stay above the maintenance requirement.
- Place stop-loss orders. Stop-loss orders can be used to sell your securities if they drop below a certain level. For example, if an investor owns a stock that has a share price of $150, they could use a stop-loss order at $125 so that their shares get sold before dropping any further.
- Contribute to your account regularly. The best thing an investor can do is to check their brokerage balance regularly and transfer additional funds as needed.
Who Determines Margin Call Amounts?
Margin maintenance levels aren’t arbitrarily set. The Financial Industry Regulatory Authority (FINRA) and the New York Stock Exchange (NYSE) each require that accountholders have at least 25 percent equity when buying on margin. For extra safety, some brokerage firms may require a greater buffer such as 30 percent or 40 percent.
The Bottom Line
Margin calls are used to let investors know that the value of their accounts has fallen below the agreed maintenance requirement. When this happens, the investor must make up the difference within 2 to 5 days or risk having their assets liquidated.
Investors can avoid margin calls by diversifying their portfolios and using less of their margin. The investor could also take preventive steps by using stop-loss orders and contributing more funds regularly.