Trading on margin offers a variety of potential benefits, as well as some additional risks, including margin calls. This lesson explains margin calls, your obligations, and what you can do to help avoid them.
A margin call is a demand from your brokerage firm to increase the amount of equity in your account. This can be done by depositing cash or marginable securities to your account or by liquidating existing positions to generate cash.
One of the most important things to understand about margin calls is that your brokerage firm has discretion as to when you are required to increase the equity in your margin account. And, while some firms will attempt to contact you to let you know that additional equity is required, they are not obligated to do so. Whether or not you have been contacted by your broker, firms can take immediate action to increase the equity in your account if they decide the equity is too low and is not commensurate with the risk of your account. This means they can immediately sell out whichever securities they choose, regardless of the financial and tax obligations for you.
To avoid margin calls, you need to fully understand what triggers a margin call, along with steps you can take to minimize the risk of a margin sellout.
As discussed in Meeting the Requirements for Margin Trading, FINRA Rule 4210 requires that you maintain a minimum of 25% equity in your margin account at all times. In practice, however, most brokerage firms have stricter requirements that demand you maintain equity of at least 30%, and in some cases, significantly more. These equity requirements can change at any time, particularly during periods of extreme market volatility. Therefore, it's important to remain vigilant at all times by closely monitoring the equity levels in your margin account.
When utilizing stock that you own as collateral for a margin loan, the value of your collateral will fluctuate as the stock price increases or decreases. But your margin loan balance remains the same or grows larger as monthly interest accrues. If the equity in your account falls below your broker’s required minimum, your account will be issued a margin call.
How to satisfy a margin call
Brokerage firms are not required to notify customers of margin calls, although most do. In some cases, a firm may simply sell shares without notifying the customer in order to bring the account equity up to or over the minimum house maintenance requirements. This usually happens in volatile markets or when there is an extreme movement of a concentrated position, as the preceding example illustrated. Still, in many cases investors are given an opportunity to choose the method and time at which they meet a margin call. When this happens, you have three options:
- Deposit cash.
Using the example above, Ellen could simply deposit $2,000 to her account.
- Deposit marginable securities.
Ellen could choose to deposit fully paid-for shares of stock as additional collateral for her margin loan. To determine how many shares would be necessary to meet a $2,000 margin call, Ellen would need to divide $2,000 by the loan value of the stock she plans to deposit. The loan value is equal to 100% minus the maintenance requirement for that stock. Assuming the maintenance requirement is 30%, Ellen would divide $2,000 by 0.70 to arrive at the figure of $2,857. That is the amount of marginable stock she would need to deposit to cover a $2,000 margin call.
- Sell shares of stock.
Similar to the calculation for depositing securities, Ellen would need to multiply the value of the stock sold by the maintenance requirement for the shares that remain in the account. Assuming a 30% maintenance requirement, Ellen would need to sell $6,670 worth of ABC Pharmaceuticals Company stock to satisfy her $2,000 margin call.
Ways to avoid margin calls
Margin calls can be a stressful experience with serious financial implications. Your brokerage firm has the right to sell shares you own at any time to increase your equity. This can be done with no written notice and without regard to the tax consequences for you. Therefore, consider these suggestions to minimize the odds of experiencing a margin call:
- Prepare for volatility: leave a considerable cash cushion in your account that protects you from a sudden drop in the value of your loan collateral.
- Set a personal trigger point: keep additional liquid resources at the ready in case you need to add money or securities to your margin account.
- Monitor your account daily: consider setting up alerts to notify you when the value of your stock declines significantly.
- Utilize your broker’s online tools: apply these tools to assist you with calculating margin requirement impact due to trading activity and/or price fluctuations of securities in your account. For example, Fidelity customers have access to a Margin Calculator that calculates the impact of hypothetical equity trades on margin balances and buying power, while also factoring in specific margin requirements for the account. Click here to see a snapshot of this calculator.