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A margin call is what happens when you don't have enough equity in your margin account. This can occur if you use your investments as collateral for a margin loan and then your account's value drops.
To satisfy the margin call, you may need to deposit cash or other assets into your account or sell investments. If you don't, your broker can sell any of the investments in your account to cover the gap between the equity in your account and what's required.
When Does a Margin Call Happen?
A margin call gets triggered when the equity in your margin account falls below the margin requirement. Your broker can then require you to increase your equity by a specific amount to satisfy the margin call.
For example, if you have $10,000 in stock and you take out a $10,000 margin loan to purchase more stock, then your equity is 50% because your initial funds make up half of the account's value.
But if the stock's price falls by 25%, you'll have $15,000 worth of stock instead of $20,000. Now, you have $5,000 in equity ($15,000 minus the $10,000 loan = $5,000), and your equity is worth 33% of the account's total value (5,000 divided by 15,000 = 0.33).
If the stock's price falls another 20%, your account's value is now $12,000, and you have $2,000 in equity, or 16.67% equity.
The Financial Industry Regulatory Authority (FINRA) has a rule that requires you to maintain at least 25% equity in your margin account. In the above example, the second value drop would trigger a margin call. You'd then need to deposit additional funds or sell off investments until you have at least 25% equity ($3,000). The New York Stock Exchange (NYSE) has a similar 25% margin maintenance requirement.
Your broker may, however, have higher house margin requirements, such as 30% or 40%. Margin requirements could depend on the brokerage firm, your portfolio and the types of trades you're doing. If you're subject to higher margin requirements, you could be subject to a margin call before your equity drops below 25%.
In addition to the maintenance margin calls, you may have an initial margin requirement of 50% when you take out a margin loan. For example, if you want to buy $20,000 worth of stock on margin, you need to invest at least half ($10,000) with cash and then borrow the other half.
You may also need at least $2,000 in your account (or $25,000 for day traders) to open and use a margin account.
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What Happens During a Margin Call?
After a margin call, you'll need to increase your equity to at least your minimum requirement. You may be able to do this in several ways:
- Add cash to your account. You can increase your equity by depositing cash into your account.
- Add marginable assets to your account. You could transfer other assets into the account, such as stocks and mutual funds. But brokers may only consider certain assets to be marginable, and the marginable amount could depend on the asset and the broker's requirements. For instance, stocks that trade for under $3 a share might not be marginable. Or, if you deposit $1,000 worth of fully marginable stock, only 70% of their value may go toward the margin call if your account has a 30% margin requirement.
- Sell investments. You could sell some of the investments in your margin account to satisfy the margin call. The amount you need to sell will depend on the amount of the margin call, the asset's price and the broker's minimum maintenance margin.
Your broker may give you several days to respond to the margin call, but it's not required to give you any warning. If it wants, a broker can sell any of the investments in your account (and potentially in other accounts at the same company) to meet the margin requirement.
An unexpected sale could result in the broker closing positions that you wanted to keep open, and you might miss out on future gains or have to pay capital gains taxes at an unfavorable time. This forced liquidation is one of the risks that comes from investing on margin.
How to Avoid a Margin Call
While you can't predict the market's ups and downs, there are several steps you can take to help avoid a margin call:
- Avoid margin accounts and only trade with cash accounts. Invest with a cash account that doesn't let you borrow money and trade on margin.
- Maintain a buffer. Keep your equity position well above your broker's house margin requirements. You could do this by keeping extra cash in the account or only using part of your margin limit.
- Diversify your investments. Using a diversified portfolio as collateral and investing in a diversified basket of assets on margin can make you less vulnerable to market volatility, which could decrease the chances of a margin call.
- Monitor your account. Frequently review your account and proactively increase your equity position before a margin call.
Having funds available to quickly transfer to your margin account can also help you avoid situations where the broker will unexpectedly sell your holdings—but only if you're given the opportunity and have the ability to act.
Review the Risks Before Investing
Understanding the risks involved with investing in different assets and accounts is important to being a successful investor. Using a margin loan to buy investments can amplify your gains, but it can also lead to larger losses and new risks. With this in mind, it may be wise to learn about investing in general before diving into investing on margin. Also, research your broker's house minimum maintenance requirements before taking out a margin loan.
If you're considering borrowing on margin and using the funds for non-investment purposes, alternative borrowing options may make more sense. Experian lets you check your credit score for free, and you can look for matches with different lenders and credit card issuers to see which loans and cards you may qualify for based on your credit profile.