All you need to know about margin call, explained with no jargon.
Last week, the news about Archegos Capital affected Wall Street heavily. When we wrote an article on that event, we felt it would be proper to follow up it with an explanatory article on the most buzzing word in the article: Margin Call
Before we explain what margin call is, we need you to understand some terms.
Margin Account
When an investor like you or me set up a margin account, that person is allowed to purchase stocks with their own funds along with borrowed funds from their broker. If you borrow funds to buy stock, the stock itself will act as the collateral for the loan. This is useful because you can enter large positions because of the boost offered by the borrowed funds.
Maintenance Margin
The other term you need to understand maintenance margin. It is the minimum value that must be maintained in a margin account. The maintenance margin is usually fixed at a minimum of 25% of the value of the securities held.
Through An Example
Let’s say that you buy ₹50,000 worth of stock using ₹25,000 of your own equity and ₹25,000 of borrowed funds from your broker. Assume that the broker has a maintenance margin of 25%. At the time of purchase your equity as a percentage is 50%. The investor’s equity is calculated using the below formula:
Investor’s Equity As Percentage = (Market Value of Securities — Borrowed Funds) / Market Value of Securities
As per our example: (₹50,000-₹25,000)/(₹50,000) = 50%
This means that the account is currently at a 50% margin, and it is above the required 25%. You make large bets with your money and everything is going fine. But the question here is what will happen if the value of the stocks decline?
Margin Call
Let’s say that the value of the stocks plunge by 50%. The value of the stock held by the margin account is now worth only ₹25,000, which is the same amount of money that you owe to the broker. This is where the problem arises. As per the deal, you are supposed to have a maintenance margin of 25%.
This is what a margin call is. The margin call occurs when the value of securities purchased on the margin decline below a certain point and reduce the overall value of the account below the maintenance margin.
Once the margin call occurs, what do you have to do? You have to add ₹12,500 (25% x 50,000) to the account to meet the maintenance margin of 25%. If you cannot do that, then the broker will liquidate stocks until the 25% maintenance margin is reached.
What To Do?
So, let’s say the value of the stocks decline, and you receive a margin call from your broker. Here’s what you can do during that situation.
- The first option is to close your position there and then
- The other would be to deposit additional funds to increase your equity above the margin requirement and support any further losses
- If possible, you can also lower the size of other positions to free up some further equity in the account
How To Avoid Margin Calls?
- Keep a significant amount of cash in your account so that it can protect you from a sudden decline in the value of your loan collateral
- Keep additional liquid resources at the ready in case you need to add money or securities to your margin account
- Consider setting up alerts so that it can notify you when the value of your stock declines sharply
We hope we helped you understand what margin call is and how you can avoid it. If you need us to explain any topic for you, you can drop us a comment, and we will do so!
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