Definition
A margin call is a broker’s demand on an investor using margin to deposit additional cash or securities so that the margin account is brought up to the minimum maintenance margin requirement. This typically occurs when the value of the securities purchased with borrowed funds falls below a certain point, making the account’s equity value too low to cover the borrowed amount.
Examples
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Stock Purchase on Margin:
An investor buys $10,000 worth of stock using $5,000 of their own money and $5,000 borrowed from their brokerage (a margin account). If the stock’s value drops to $8,000, resulting in the equity value falling below the maintenance margin of, say, $4,000, the broker would issue a margin call asking the investor to deposit an additional $1,000 or sell some securities to cover the shortfall.
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Futures Trading:
In the futures market, if the value of the futures contract falls, the margin account will also decline. For instance, if an initial margin of $1,000 is required and the account value drops to $600, a margin call will be issued to bring the account back to the initial margin requirement.
Frequently Asked Questions (FAQs)
What triggers a margin call?
A margin call is triggered when the value of the securities in a margin account drops below a certain level, causing the equity in the account to fall below the brokerage’s required minimum.
What happens if you don’t meet a margin call?
If you fail to respond to a margin call, your securities in the margin account may be sold by the brokerage to bring the account back to the required level.
Can a margin call be avoided?
Yes, investors can avoid margin calls by not leveraging their accounts too highly and maintaining a significant buffer of equity over the maintenance margin requirement.
Is a margin call bad?
A margin call can be a sign of financial trouble as it indicates that the value of the investments has dropped significantly. However, it can also serve as a reminder to reassess and manage investment risks.
How quickly must a margin call be met?
Brokers typically require margin calls to be met within a few days, though the specific time frame can vary by brokerage.
- Margin Account: A brokerage account in which the broker lends the customer money to purchase securities, with the securities serving as collateral.
- Maintenance Margin: The minimum amount of equity that must be maintained in a margin account.
- Leverage: Using borrowed capital to increase the potential return of an investment.
- Liquidation: The process of selling an asset or security to cover an obligation, such as a margin call.
Online References
Suggested Books for Further Studies
- “The Little Book of Behavioral Investing: How Not to Be Your Own Worst Enemy” by James Montier
- “The Intelligent Investor” by Benjamin Graham
- “A Random Walk Down Wall Street” by Burton G. Malkiel
- “Margin of Safety: Risk-Averse Value Investing Strategies for the Thoughtful Investor” by Seth A. Klarman
- “Reliability of Margin Call Systems and Margin Coverage” by Christian Hecker
Fundamentals of Margin Call: Finance Basics Quiz
### Does a margin call occur because a portfolio’s value has increased?
- [ ] Yes, it means the account has more equity than required.
- [x] No, it occurs when the portfolio’s value falls below a certain level.
- [ ] It is unrelated to the value of the portfolio.
- [ ] Only if the account is inactive for a long period.
> **Explanation:** A margin call occurs when the account’s equity falls below the required minimum maintenance margin due to a decline in the portfolio’s value.
### What must an investor do when a margin call is issued?
- [x] Deposit additional funds or securities.
- [ ] Sell their entire portfolio.
- [ ] Close the margin account immediately.
- [ ] Notify the brokerage of their next actions.
> **Explanation:** When a margin call is issued, the investor must deposit additional funds or securities to bring the account up to the required margin level.
### What may the brokerage do if a margin call is not met?
- [x] Liquidate securities in the margin account.
- [ ] Increase the leverage limit.
- [ ] Offer additional loans.
- [ ] Close other unrelated accounts.
> **Explanation:** If a margin call is not met, the brokerage may liquidate the securities in the margin account to bring the account up to the required level.
### What type of account typically issues margin calls?
- [ ] Savings accounts
- [x] Margin accounts
- [ ] Checking accounts
- [ ] Retirement accounts
> **Explanation:** Margin calls are typically issued in margin accounts where the broker has lent money to the investor for purchasing securities.
### Which of the following can help avoid margin calls?
- [x] Maintaining a significant buffer of equity above the maintenance margin.
- [ ] Investing exclusively in low-risk assets.
- [ ] Leveraging the entire account.
- [ ] Frequent trading.
> **Explanation:** Maintaining a significant buffer of equity above the maintenance margin can help in avoiding margin calls.
### What is usually held as collateral in a margin account?
- [ ] Cash only
- [ ] Real estate
- [ ] Gold
- [x] Securities purchased with the borrowed funds
> **Explanation:** The securities purchased with borrowed funds typically serve as collateral in a margin account.
### How does leverage relate to margin accounts?
- [ ] Leverage decreases potential gains.
- [x] Leverage increases potential returns and risks.
- [ ] Leverage eliminates the need for a margin call.
- [ ] Leverage is irrelevant to margin accounts.
> **Explanation:** Leverage increases potential returns but also increases risks, which is why it's relevant to margin accounts.
### What happens to the initial margin requirement if the price of the stock increases?
- [ ] It will always decrease.
- [x] The initial margin requirement usually stays the same.
- [ ] It will always increase.
- [ ] It gets eliminated.
> **Explanation:** The initial margin requirement usually stays the same regardless of the changes in the stock's price.
### When referring to a margin call, what does ‘equity’ mean?
- [x] The value of securities minus the borrowed amount.
- [ ] The total amount of cash in the account.
- [ ] Only the borrowed amount.
- [ ] A mix of portfolio’s value and cash.
> **Explanation:** In the context of a margin call, ‘equity’ refers to the value of the securities minus the borrowed amount.
### In what circumstance is it possible to leverage a margin account?
- [x] When the account holder opts for borrowing against investment securities.
- [ ] When the account holder does not trade for long periods.
- [ ] After liquidating all positions.
- [ ] Only in retirement accounts.
> **Explanation:** It's possible to leverage a margin account when the account holder opts for borrowing against the value of their investment securities.
Thank you for taking the time to understand the intricate details of margin calls with our thorough guide, and for testing your knowledge with our quiz. Keep educating yourself to manage financial risks effectively!
