You might be tempted to trade with a margin account … But you gotta know that if things don’t go well, you can face the dreaded margin call.
Let’s face it, risk is one of the most important aspects of the stock market. It helps make meaty profits possible. But there’s a downside to risk — the possibility of losing.
There’s no such thing as risk-free trading. All traders take on some risk. And some choose to take on more, hoping to make even larger profits in a shorter time frame. One way is by trading from what’s called a margin account.
When you first open a brokerage account, you’ll be able to choose between two account types: cash or margin. Your selection can make a big difference in how you trade.
A margin account allows traders to trade stocks with borrowed funds. Basically, the brokerage loans traders money, charges them interest, and then uses their accounts equity as collateral.
Trading with a margin account can give you access to more trading capital, and that allows you to buy larger share sizes. The upside would be the potential for higher gains…
But hang on…
There’s a staggering downside. Trading with a margin account is risky. Why? You’re trading with borrowed money — it isn’t really yours. And if a trade doesn’t go your way, you may have the unfortunate experience of dealing with a margin call.
Table of Contents
What Is A Margin Call?
A margin call is a broker’s demand for a trader to deposit more money or stock securities to bring a margin account back to the broker’s minimum requirement.
This happens when a trader loses enough that the equity amount being held as collateral falls below this minimum value.
How Do Margin Calls Work?
A margin call isn’t something you want to receive. And depending on the size of the loss, it can be a big setback to your trading journey.
It’s important to understand how margin calls work if you want to trade from a margin account successfully, so let’s take a closer look.
What Happens When You Get a Margin Call?
When a trader gets a margin call alert, they normally have anywhere from two to five days to meet the call requirements. That alert may come as a notification on the broker’s website when the trader logs in to their account, but it could also be an email, a text message, or even a phone call.
If that trader doesn’t fulfill the margin call in time, the broker can sell the trader’s securities without notification and can choose which positions to liquidate. In addition, they can charge commissions for transactions and sue for losses.
What Triggers Margin Calls?
The Federal Reserve enacted Regulation T to enable the nation’s central bank to enforce minimum margin requirements.
As an example, one of the provisions states that, when dealing with stocks on the New York Stock Exchange, the borrower has to have at least 50% equity at the time of purchase of that stock. After that, the borrower must maintain 25% equity in their account at all times.
Although the Fed sets the basic rules, you should know that each broker has its own requirements. And sometimes, those restrictions may be even stricter.
The minimum amount of the trader’s equity that must be in the account is called the maintenance margin, and it’s often expressed as a percentage. That percentage of your account’s value must come from your own money — not from borrowed funds.
If a trader’s equity, as a percentage of the total market value of the stocks, doesn’t meet minimum requirements, the broker can send out a margin call. Brokers can also send out margin calls if it changes its margin policies or if they believe the borrower is too risky.
Margin Call Formula
How do you calculate a margin call? Well, since brokers have different maintenance margins and because every stock has a different price, we need a formula to determine the price figures.
In individual cases, you can calculate the exact stock price on which a margin call will be triggered with the following formula:
Account Value = (Margin Loan) / (1 – Maintenance Margin %)
Example of a Margin Call
Let’s look at an example. Say you open a margin account with $15,000 of your own money. You then borrow $15,000 from your broker as a margin loan so that you can purchase more shares. If your broker’s maintenance margin was 30% and you bought 300 shares of a stock at $100 each, here’s what the numbers would look like:
($15,000 Margin loan) / (1 – 0.30 Maintenance Margin %) = $21,428.57 Account Value
In this case, a margin call would be triggered if your account value fell below $21,428.57 — or if the stock’s price fell below $71.43 ($21,428.57 / 300 shares).
See how that works?
What to Do After a Margin Call
Once you receive a margin call, you really only have three options to get back in good standing…
#1 Deposit Cash to Meet the Margin Call
The first option is to simply deposit more cash to bring your equity back to the minimum requirement.
Using the example above, let’s say the stock falls from $100 per share to $70 per share. This would bring your account value to $21,000 ($70 stock price x 300 shares).
Because the broker’s loan value doesn’t change ($15,000), your equity is now $6,000 ($21,000 new account value – $15,000 borrowed funds).
That brings your equity percentage down to 28.57%…
($21,000 new account value – $15,000 loan) / ($21,000 new account value)…
That’s below the required maintenance margin of 30%.
Here’s the formula used to calculate the cash deposit you need to meet the maintenance margin on a margin call:
(Market Value of Securities x Maintenance Margin) – Investor’s New Equity = Cash Deposit to Meet Maintenance Margin
Using the formula we get the following:
($21,000 x 0.30) – $6000 = $300
In this case, you’d receive a margin call to deposit $300 by the due date.
#2 Depositing Securities to Meet the Margin Call
Another option to meet the margin call is to deposit stock securities into your margin account.
Remember the formula we used earlier where the securities purchased had to equal $21,428.57?
To use this option, you simply need to deposit more securities to match the missing difference. In this case, it would have to be $428.57 in securities ($21,428.57 required account value – $21,000 new account value).
#3 Liquidating Stock to Meet the Margin Call
If you can’t deposit more cash or add more securities to meet the margin call, your only option would be to liquidate stock and reduce your margin loan.
In this case, you’d need to sell $1,000 worth of stock (or 15 shares). This would lower your margin loan to $14,000 and the existing $6,000 in equity would meet the maintenance margin minimum of 30%.
How to Avoid Margin Calls
It’s probably safe to say that no one wants to receive a margin call. It can be stressful, especially if you trade with a smaller account. Lucky for you, it’s pretty easy to avoid margin calls. Here are different things you can do to lower the chances of it ever happening…
Don’t use your entire margin buying power. Just because you have it doesn’t mean you should use it. Remember that the more you use borrowed funds, the more risk you take on. It’s not necessary, and there are plenty of other ways to trade, even if you have a small account.
Don’t put all your eggs in one basket. Diversifying your investments can be one way to limit your risk. If you put all of your borrowed funds into one trade, the bigger your losses will be if the trade goes south.
Avoid trading on margin with new setups. If you’re gonna use borrowed funds, make sure to use it on setups that you have a lot of experience and success with. Have a new setup you want to test with no risk? Check out StocksToTrade’s paper trading feature.
Keep liquefied assets available. If you do get a margin call, make sure you have funds to protect your account.
Don’t open a margin account. The easiest way to avoid a margin call is to not trade with one. If you don’t have the stomach to take on the additional risks, open up a cash account. There are limitations that come with both account types. But trading with your own money using a cash account can help you better understand the risks. When your own money is on the line, it can help you choose trades more carefully.
If you’re tempted to trade with a margin account, remember that your losses can be amplified and staggering.
How Do I Stop a Margin Call?
If your account falls under the maintenance margin minimum and your broker chooses to open a margin call, there isn’t a lot you can do to stop it. Although, you may get better service from more reputable brokers that you have a good relationship with.
In many cases, brokers have software programs to monitor declines in equity, and they probably won’t give you a time extension to bring it back up.
Brokers are typically interested in protecting themselves financially and don’t want to go after you to collect a debt. They may begin selling off your shares to raise as much cash as possible. And they’re under no obligation to give you notice.
The best thing you can do is to monitor your account regularly and be very aware of what’s happening with your trades. If you can’t do your due diligence to protect yourself in trading, you shouldn’t trade with a margin account.
In fact, that’s a strong signal that it’s time to focus on your market education…
Conclusion
If you’re gonna trade in the stock market, you will deal with risk … It’s up to you to choose how much risk you can afford and what fits your overall trading style.
Because margin accounts allow you to trade with borrowed money, it introduces new levels of both reward and risk. Emphasis on the risk.
Here at StocksToTrade Pro, we’re huge advocates for market education. We take the market one trade at a time.
We’d rather trade like a sniper and make the best trade possible than take unnecessary risks with margin accounts. Every trader is different, but if you want to learn to trade consistently, it’s key to learn to use your funds wisely, habitually manage your trades, and always know where your account stands.
Wanna avoid those nasty margin calls? Easy. Don’t trade with a margin account. You can build up a small account…
In StocksToTrade Pro, that’s exactly what we teach every day — and so much more. Be more prepared than the average trader … Come join us today!
Have you traded from a margin account? Leave a comment!