What is a margin call? This is a question we get all the time so we put together this guide on trading with margin and what to do if you get a margin call.
Borrowing money is a way of life in our society. Whether you take out a mortgage to buy a house or student loans for college, borrowing money is how we finance large purchases.
Could you imagine having to save $200,000 in cold hard cash for that starter home in order to purchase it?
Most people would rent for the rest of their lives! Borrowing money allows us to use future earnings today, a key point of emphasis in the life cycle theory of personal finance.
But enough with the personal finance examples. We aren’t looking to buy houses or pay for college with our day trading accounts, but that doesn’t mean we can’t borrow cash. Brokers often lend investors cash in the form of margin.
By borrowing money against their current capital, traders can juice their returns via leverage and take home profits twice as big as normal. However, no investment is without risk – and margin doubles that risk.
Using margin can increase your returns, but several consequences come with it, including the potential forced sale of your stocks.
What is Margin?
Margin simply means borrowed money. If you’re trading on margin, you’re using both your own capital and cash from your broker.
When using margin, the cash and securities in your brokerage account will act as collateral for a loan you receive from the broker.
For example, let’s say you want to purchase $4,000 worth of AAPL shares, but only have $2,000 in your trading account. By using margin, you can borrow $2,000 from the broker using the money already in your account as collateral.
After a month, maybe your investment is worth $5,000 and you decide to return the loan to the broker. You’ll repay $2,000 you borrowed (plus interest, fees, and/or commissions) and keep $3,000, which includes $1,000 in profits. Congrats, you’ve now doubled your gains!
FINRA and the stock exchanges have strict rules on margin. Our $2,000 example wasn’t chosen at random – that’s the minimum required by the NYSE to open a margin account (although your broker may impose higher limits).
Additionally, you can only borrow up to 50% of the cash needed to fund your investment, so an account with $2,000 will only be able to borrow an additional $2,000 at most. This is known as “initial margin”.
Once you’ve executed your trade, you’ll need to keep your account funded to a level known as “maintenance margin” to avoid the dreaded margin call.
FINRA and the SEC require maintenance margin to be at least 25%, but many brokers demand 30% or more.
How does maintenance margin work? If you buy $4,000 worth of AAPL on 50% margin, you’re on the hook for the borrowed $2,000 regardless of how the investment performs.
If Apple has a bad earnings report and your investment loses $1,000, you’ll have $3,000 left in your account. Not ideal, but not awful, right? However, since $2,000 is borrowed and belongs to your broker, your remaining equity is actually only $1,000.
And since $1,000 falls below the 30% maintenance threshold, your broker will issue a margin call. You don’t want to be issued a margin call.
Differences Between Margin and Cash Accounts
All investors start with cash accounts. Cash accounts are your basic brokerage vehicle, enabling traders to buy and sell securities based on how much cash they deposit.
If you put $3,000 into a cash account, you can buy $3,000 worth of Amazon stock. No money can be borrowed and certain account restrictions apply to things like short-selling and options trading.
Cash accounts are also subject to settlement rules.
If you sell those AMZN shares, you can’t immediately withdraw your cash or make a day trade. According to SEC regulations, you need to wait for the funds to “settle”.
This is known in the industry as T+2, or Trade Date plus 2 business days. If you sell your AMZN shares on Monday, you can’t buy AND sell another security until the funds settle on Wednesday. For most investors, this means no day trading.
Day trading with unsettled funds in a cash account could result in a Good Faith Violation (GFV). If you’re issued four GFVs in a rolling 12-month period, your account will be restricted.
For 3 months, you’ll only be allowed to trade with settled cash – a nightmare scenario for anyone hoping to day trade.
Margin accounts have much fewer restrictions but more responsibility.
Since margin accounts allow for borrowing, short-selling and complex options trades are allowed. Futures contracts can also be traded in margin accounts.
Traders can also avoid the settlement rules in margin accounts by use of short-term margin loans.
You can withdraw cash immediately after selling shares and use the settled cash when it clears.
However, you’ll need permission to use a margin account. Most brokers require you to apply and be approved for use of margin.
And obviously, each broker has their own interest rates and fee schedules. Margin isn’t free!
You’ll also be subject to the Pattern Day Trader Rule, which requires accounts to have over $25k if you place more than 3 day trades in a 5 business period.
Make sure you understand the terms and conditions of borrowing from your broker before opening a margin account.
What is a Margin Call?
If you fall below the maintenance margin limits set by your broker (usually 30%), you’ll be issued a margin call. And that’s just about the worst news you can receive as a day trader.
A margin call is basically an ultimatum: find some cash or else. You’ll need to get your account back over the 30% threshold quickly or your broker will take action.
What actions can your broker take?
- If you have stocks in your account, your broker can take control and sell some of your securities to meet the call. Here’s the kicker – they don’t even need to tell you they’re doing this. They can sell any shares they want, including stocks that trigger taxable events on your end. And they’ll charge commission for the pleasure!
- If you don’t have enough equity to cover the call, you’ll become indebted to your broker. Unpaid debts will be reported to credit agencies, which could tank your FICO score and make it difficult to borrow money from other lenders.
- An unpaid brokerage debt could result in a lawsuit against you. If you’re sued by your broker, you’re no longer just on the hook for the loaned money; now legal fees come into play.
A margin call requires immediate action. You’ll usually have a couple business days, but don’t expect a grace period or extension. Pay up to meet the call, or your broker will decide how to pay for you.
What Do You Do if You Receive a Margin Call?
If you receive a margin call, you’ll need to act quickly.
Traders using margin need to keep a close eye on their accounts because if you’re issued a margin call, your broker won’t call and tell you about it.
If a margin call is issued, you need to find enough cash to bring your account back above the maintenance threshold or face the forced liquidation of your securities.
The simplest way to meet a margin call is to deposit some cash. In our example above, a margin call was issued because the equity in the account dropped to 25% ($1000 out of a $4000 initial investment).
If the maintenance margin is 30%, you would need to deposit $200 to bring the account back up to $1200 (4000 x 0.3 = 1200). Additionally, you can sell stock to meet the call.
Selling $155 worth of stock would reduce your investment value to $3845, which would reset the 30% maintenance margin to $1153.50. Adding $155 to your $1000 in equity brings the account back above the 30% threshold.
How To Avoid a Margin Call
- Use a cash account – Want to avoid a margin call? Don’t use margin! You can still day trade in cash accounts as long as you have the capital to make the trade. Margin calls are still possible in cash accounts, but only if you can’t afford commissions.
- Invest in low risk securities – You can use margin to buy less risky securities like ETFs, mutual funds, or government bonds. Using margin on ETFs and bonds isn’t the most exciting use of capital, but you can generate better than average returns without taking on excess risk.
- Have ample savings on hand in a different vehicle – A good way to avoid the stress of a margin call is to have plenty of cash sitting on hand in a different type of account. If you have both a cash and margin account with your broker, they’ll likely let you use funds from the cash account to meet a call on the margin account. Likewise, a high-yield savings account is a good vehicle for liquid cash that doesn’t deteriorate purchasing power.
- Don’t be reckless – Having a margin account is like getting a credit card from your broker. If you use it when you need it and don’t spend frivolously, you won’t run into problems. Likewise, if you use margin responsibly, you won’t have to stress over margin calls. Don’t spread your capital too thin and always stick to your trading guidelines. And remember, you don’t need to borrow 50% every time – a 15% or 20% loan can help juice your returns too.
Most day traders can successfully use margin without getting into trouble.
Borrowing from your broker is a great way to increase returns with limited capital, but you still need to be careful, especially if you’re new to day trading. Leverage works both ways and a single trade can blow up your account if you use margin irresponsibly.
Always stick to your trading plan and use the strategies you’re comfortable with. Remember, getting issued a margin call is no reason to panic.
But you do need to act promptly – otherwise your broker will take action for you.