A margin call occurs when the broker of a margin account demands additional money or securities be added to an account to bring the amount of equity in the account up to its designated maintenance margin.
If the account holder fails to add enough cash or securities to the account to bring it up to the maintenance margin, then the broker will liquidate securities from the account until the maintenance margin is met.
A maintenance margin is the minimum amount of equity in an account relative to the account’s liabilities that is required by the broker. Different brokers and different asset classes can all have varying maintenance margins.
The margin call occurs when the value of securities purchased on margin drop below a certain point and reduce the overall value of the account below the maintenance margin.
In rare circumstances, a margin call can also occur when the maintenance margin formula for an asset class is changed while the account holder is currently borrowing on margin to hold that asset class.
Margin Call Example
Suppose that a margin account holder buys $10,000 worth of stock using $5,000 of his own equity and $5,000 of borrowed funds from his broker. Furthermore, suppose that the broker has a maintenance margin of 25%. This would mean that the account is currently at a 50% margin, where the account holder’s equity makes up 50% of the entire value of the account, which is above the required 25%.
Now imagine that the value of the stocks falls by 50%. The value of the stock held by the account is now worth $5,000, which is the same as the amount that the account holder owes to the broker, leaving the account holder with a margin ratio of 0%. To meet the maintenance margin of 25%, the account holder will need to add $1,250 to the account or the broker will liquidate stock until the 25% maintenance margin is reached.
The danger of margin calls comes from the automatic liquidation by the broker, which is often done at unfavorable times. Weathering the noise of the regular ups and downs of price movements is an inherent part of investing.
However, if your leverage ratio is so high that you are forced to liquidate some or all of your positions every time that the price of a stock goes down, then you will struggle to hold sizeable positions that capture any eventual increase in price.
Trading on margin is an important element of many trading strategies, but the effects of margin calls must be well understood and incorporated into the ideal amount of leverage used in your strategy.