Margin calls are notices issued by brokerage firms when a client's equity in an account falls below the required maintenance margin. This indicates that the account is at risk of becoming undermargined. To mitigate this risk, the client must promptly deposit additional funds into their account to bring their equity up to the required level. Failure to do so may result in the liquidation of positions to satisfy the margin requirement.
What are margin calls?
A margin call occurs when the value of an investor's margin account falls below the minimum maintenance margin required by the brokerage. In such cases, the brokerage firm demands that the investor restore the account to the required level. This can be done by depositing additional funds, adding unmargined securities, or selling some of the current positions to make up the shortfall. A margin call ensures that the broker’s lent amount is adequately secured against market fluctuations.
How do margin calls work?
Margin calls are triggered when the equity in a margin account falls below a predetermined maintenance margin level. This occurs when the market value of the securities held in the account declines significantly, resulting in the account's equity becoming insufficient to cover the margin debt.
To illustrate, consider a scenario where the initial margin requirement is 50% and the maintenance margin is 25%. If an investor purchases securities worth Rs. 10,000, the initial margin would be Rs. 5,000, and the remaining Rs. 5,000 would be borrowed from the broker.
Should the value of the securities subsequently decline by 40%, the account's equity would decrease to Rs. 1,000, falling below the maintenance margin of Rs. 1,500. This triggers a margin call, requiring the investor to deposit additional funds to bring the equity back up to the required level. If the equity value were to fall to zero, the broker would liquidate the securities held in the account to recover the outstanding margin debt.
Formula for margin call price
The margin call price is calculated using the formula:
Margin Call Price = Initial Purchase Price × (1−Initial Margin/1−Maintenance Margin)
Where:
- Initial purchase price: The cost of the security when purchased.
- Initial margin: The minimum percentage of the purchase price that the investor must pay upfront.
- Maintenance margin: The percentage of equity that must be maintained in the margin account at all times.
This formula determines the threshold price at which a margin call would be triggered.
Example of a margin call
Scenario:
An investor purchases shares of a company listed on the NSE for Rs. 10,000, using Rs. 5,000 of their own funds and borrowing Rs. 5,000 from a broker. The initial margin is 50%, and the maintenance margin is 25%. At what price will the investor receive a margin call?
Calculation:
Using the formula:
Margin Call Price = Initial Purchase Price × (1 − Initial Margin/1 − Maintenance Margin)
Margin Call Price = Rs. 10,000 × (1 − 0.50 / 1 − 0.25)
Margin Call Price = Rs. 10,000 × (0.50/0.75)
Margin Call Price = Rs. 10,000 × 0.6667
Margin Call Price = Rs. 6,667
Interpretation:
If the stock price drops below Rs. 6,667, the investor will receive a margin call.
For example:
- If the stock price is Rs. 6,667, the broker’s loan accounts for 75% (Rs. 5,000/Rs. 6,667), while the investor's equity is 25% (Rs. 6,667 - Rs. 5,000).
- If the price falls further to Rs. 6,000, the broker's share becomes 83.33% (Rs. 5,000/Rs. 6,000), leaving the investor with just 16.67% equity, triggering a margin call to maintain the required 25% equity level.
How to answer margin calls?
Let us assume here that, unfortunately, you have been hit with a margin call. At this point, you can:
- Infuse additional funds into your trading account to achieve the maintenance margin level
- Transfer more securities into the account to reach the maintenance margin
- Close your trades to bridge the gap between the account’s funds and the minimum maintenance margin level
- Wait for the value of your portfolio to increase before it is liquidated
Typically, after a margin call is issued, you have around five days to meet the maintenance margin level. The actual time may be even shorter depending on your account, broker, and market conditions, among other factors. However, failure to comply with the margin calls will empower your broker to liquidate your portfolio without your permission.
What happens if you get a margin call?
By now, it must be clear that trading on margins is a risky proposition, especially for beginners. Like utilising call and put options, trading on margins is not necessary to earn profit. However, it does open up avenues for higher returns—or losses, in case the market moves against you. Margin calls can be issued by brokers under the following circumstances:
- The decline in the value of a security held in the trading account, leading to the account value to fall below the maintenance margin.
- The terms for maintenance margins vary among brokers in the market and are also liable to change depending on market circumstances. For example, the maintenance margin levels may be raised during market volatility or turbulence. Thus, it is important to constantly track your account and market trends.
- Excessive borrowing on the account to secure bigger trades.
Brokers will keep you updated and notified on approaching the maintenance margin so that you can infuse capital back into the account with sufficient time.
How to avoid margin calls?
Getting a margin call is not the best thing to happen to you. However, the best strategy against it is to avoid it altogether. While not trading on margins is the simplest way to avoid margin calls, here are some other ways to avoid a margin call:
- Keep additional cash reserves
Maintain extra funds in your account to cover fluctuations. Unlike securities, cash retains a stable value, serving as a buffer to meet margin requirements without liquidating your positions. - Diversify your portfolio
Invest across a range of assets, such as stocks, bonds, commodities, and derivatives. Diversification reduces the impact of volatile price movements in any single security, lowering the risk of breaching the maintenance margin. - Regularly monitor your account
Regular checks on your margin account enable you to track whether the account value is nearing the maintenance margin. This allows you to act proactively, such as adding funds or adjusting your positions, to prevent a margin call. - Set a personal maintenance margin
Define a personal maintenance margin that is stricter than the broker’s requirement. If your account nears this self-determined threshold, you can deposit funds or liquidate some positions to avoid triggering a margin call.
By employing these measures, you can minimise the risks associated with margin trading and ensure better control over your investments.
Conclusion
Margin calls are critical alerts from brokers requiring traders to replenish their account balance to the maintenance margin level to avoid liquidation of their positions. To prevent margin calls, traders should maintain additional cash reserves, diversify their portfolios to mitigate risk, and diligently monitor their account balances, especially during volatile market conditions. Understanding and managing margin requirements is essential for safeguarding your investments and ensuring financial stability.
