Margin Call: What it is, how it works and how to avoid it

When the value of the securities held in a brokerage account goes below the maintenance margin, the account holder receives a margin call. In this case, the investor must either deposit more cash or securities to bring the account's margin value back up to the required level. Accounts using borrowed funds to buy stocks are subject to margin calls, and these calls typically occur in rapidly dropping markets. Here is all you need to know about margin call meaning, how it works, and how it can be avoided. 

What is a margin call? 

Do you know what is a margin call? When an investor's margin account falls below the minimum needed by their brokerage, the investor receives a margin call and is forced to replenish the account with cash or equity. Margin debt refers to money borrowed from a brokerage to purchase investments. When the value of those investments drops, the broker will issue a margin call. 

How margin calls work 

The brokerage issues a margin call in the stock market when an investor’s account equity falls below a certain level. If the investor replenishes the account, the dispute is settled, unless again, the proportion of account equity to account value decreases. 

Suppose an investor is unable or unwilling to pay a margin call. In that case, the brokerage may liquidate (also known as "force a sale") all or a portion of the assets held in the account (and often the investor's other accounts held with the brokerage) to cover the shortfall. Investors have no say over which securities are sold in these situations; it is entirely up to the discretion of the brokerage. 

If the proceeds from the forced sales are insufficient, the brokerage may pursue legal action to recoup the difference from the investor. An investor’s credit score could take a hit if their brokerage account is shorted, and they need to improve on the shortfall within the required time frame.  

Brokers disclose this information to credit bureaus. Suppose an investor frequently fails to meet maintenance margin requirements and is therefore forced to liquidate. In that case, the broker may impose limits on the account (such as increased maintenance margin requirements), eliminate the margin feature, or terminate the account. 

At their discretion, brokers may issue extensions on margin calls, but extensions are not available for federal or exchange calls. Bear in mind that brokerages have extensive leeway with margin calls and can require fast fulfillment. 

When do margin calls happen? 

Margin calls are more common in times of severe market volatility, but they can happen at any moment. When the value of an asset you own falls below the maintenance margin, it causes your margin account to go into the negative. A margin call occurs when the importance of security on which you have a short position rises. Then, you'll have to top off your trading account with fresh funds until you reach the needed maintenance margin. This capital may take the form of cash or new securities. When a broker issues a margin call, the client can either make a deposit or sell an asset. 

Types of margin calls  

Margin calls can be divided into three distinct categories. Investors should expect several margin calls based on the margin requirements they failed to meet: 

Federal calls:

Also known as "initial calls" or "federal calls," these calls occur when an investor fails to provide the required initial margin for a transaction. 

Exchange calls:

When an investor's equity in their account falls below a certain threshold, the exchange call provision kicks in. 

Maintenance calls:

A maintenance call, also known as a "house" or "brokerage" call, is issued when an account's equity falls below a predetermined threshold. 

How a margin call is calculated

Now that you know the margin call definition, it’s time to know how it is calculated. For example, you have deposited Rs 10,000 and borrowed another Rs 10,000 on margin from your broker, giving you a total of Rs 20,000. Using your spare Rs 20,000, you buy 200 shares of XYZ Company at Rs 100 each. Your maintenance margin is 30 percent. 

For this account, a margin call would occur if the account value drops below Rs 14,285.71. Therefore, you will receive a margin call if the price of XYZ stock drops to Rs 71.42 or lower.  

Let's imagine you invest Rs 100 in Company XYZ, but then sometime later, they announce poor financial results, and the stock drops to Rs 60. There are currently 200 shares in the account worth Rs 12,000 (at Rs 60 each), leaving you Rs 1,600 shy of the 30% margin call. The following choices are available to you:   

Transfer Rs 1,600 into the account to respond to the margin call. 

Deposit Rs 1,600 into the account in the form of marginal securities. 

To satisfy the margin call and increase your account equity to 30%, you should sell Rs 3,333.33 worth of XYZ stock. 

This is the very minimum that must be done to get you back into maintenance margin compliance. If the stock price drops further, additional equity funding may be required.  

Remember that you are responsible for covering any losses and repaying the broker for its loan. So, let's say you put in Rs 10,000 of your cash and borrowed another Rs 10,000 on margin. Even if the stock fell by only 40%, the value of your account dropped to Rs 12,000, leaving you with only Rs 2,000 in equity and an 80% loss. 

Your broker may not give you much advance notice of a margin call and may sell securities in your account without your consent. In times of significant market volatility, brokers may strive to limit their exposure by immediately demanding repayment of margin loans. 

How to avoid a margin call

If you want to prevent margin calls, it's preferable not to trade on margin or even use a margin account. Only experienced traders who can devote time and attention to their portfolios should use margin trading. Margin trading investors can avoid a margin call using the following ways: 

Investors can learn the ins and outs of margin trading and get familiar with their broker's maintenance margin needs. 

Investors can keep an eye on the market's fluctuations by keeping tabs on the price of stocks, bonds, or other securities in which they have a margin account. 

Investors can prepare for a possible margin call by estimating the lowest price at which their broker could issue a call and setting aside funds to cover the shortfall. 

A limit order is one sort of order that may assist protect an investor from a margin call. A limit order guarantees that your order is fulfilled at or better than the specified price. It can be used along with stop orders to prevent huge losses. 

Conclusion 

To prevent a margin call, you must increase the amount of cash and securities in your account, or sell some of your current assets, to bring the total amount of equity in your account up to the required level. Due to the high frequency with which margin calls occur during times of high market volatility, you may be obliged to sell stocks at depressed prices. Most investors putting money down for a long-term goal, like retirement, should avoid buying stocks on margin. 

FAQs 

Q. What are some strategies for responding to a margin call? 

To respond to a margin call, traders can sell stocks from their margin account or deposit cash into their account. 

Q. What are the key distinctions between receiving a house or fed call? 

An investor's margin account needs more equity to retire 50% of their margin position as required by Regulation T, or else the investor will receive a federal call. In contrast, when an investor's margin equity falls below the maintenance margin, a house call is made. 

Q. Within what time frame must you meet a margin call? 

The time frame varies from broker to broker. In some cases, brokers may require that margin calls be paid in full as soon as they are received. In other situations, the broker may give you up to five days to pay the margin.