3) Margin Trading: The Dreaded Margin Call
The focus of this section of the tutorial is the maintenance margin and the dreaded margin call. A maintenance margin is the minimum balance you must maintain in your account. A margin call is when your account balance falls below the minimum. When a margin call happens, you must add more funds to your account or liquidate stocks.
Picture this scenario on how a margin call can happen:
John bought stocks worth $30,000 by borrowing $15,000 from the broker and paying the other half from his own money. The market value of the stocks suddenly drops to $25,000, so the equity in his account also falls to $10,000 ($25,000 – $15,000 is $10,000). The maintenance margin set by the broker is 25%. John is still within the requirement since 25% of $25,000 is $6,250, and his equity is at $10,000.
Now what if the broker‘s maintenance requirement is 45%? Would John have enough equity in his account? The answer is no. 45% of $25,000 is $11,250 which is higher than John’s remaining equity of $10,000. If this happens, the broker can issue John a margin call.
If for some reason you aren’t able to meet a margin call, the broker has rights to sell your securities to increase your account equity until it is above the maintenance margin. In most margin agreements, a brokerage can sell your securities without the need to wait for you to meet the margin call, and they are given full control over which stock to sell to cover it.
For this reason, it is imperative that you read the agreement thoroughly and understand its implications before investing. The the terms and condtions of the margin account explains everything including: interest on the loan, payment responsibilities, and how marginable securities are collateral.