A margin call occurs when a trader is told that their brokerage balance has dropped below the minimum equity amounts mandated by margin requirements. Traders who get a margin call must quickly deposit more cash or securities into their account. If they don't, the firm may begin liquidating the trader's positions to cover margin requirements. Margin calls only apply to traders who trade "on margin," which means that they use borrowed funds to trade.
Here's what you need to know about margin calls, and a few strategies you can use to avoid them.
- A brokerage firm issues a margin call to inform a trader that they have fallen out of line with margin requirements and they need to add equity to their account.
- Failure to add equity after a margin call has been issued can result in the firm selling off your positions at will.
- Margin requirements vary by brokerage firm, account type, trade type, and the types of securities being traded.
What Is a Margin Call?
A margin call is a warning that your margin account's equity balance has fallen too low and it no longer satisfies the margin requirements. A margin call tells traders that they must add funds to their account, either by depositing cash or transferring securities to the account. If they fail to do so, then the contents of their account could be at risk.
How Does a Margin Call Work?
If you receive a margin call, you must take prompt action to increase the equity in your brokerage account. An easy way to do this is to add more cash into your account. You can also transfer stocks or other securities into the account, or in some cases sell some of your holdings to lower the amount you owe to the firm, if you are trading on credit.
Margin calls first got their name because the firm would issue the news by calling the trader on the phone. Your firm may or may not still conduct margin calls via phone call. Text or email are more common these days. They may also simply close certain positions after a margin call has been issued without warning, if this is in the terms of your account contract.
It's best to ask your firm about how margin calls will be issued when you first set up an account. You should know how much time you have to respond to the margin call (by adding money to your account), and whether they are in the practice of closing positions automatically.
In most cases you'll have a few days to fix the problem after a margin call has been issued. The exact amount of time depends on your firm. If the deadline has passed and you still haven't taken action, your firm may sell off positions in your account at will to try to put your account back within margin requirements. You will not have a say in what positions are closed, or what price the trades sell at.
What Is the Basis for a Margin Call?
When a margin call happens is based on rules set by both federal authorities and individual brokerage firms. Margin requirements are standards that provide a set amount of cash a trader must have at each stage of a purchase on credit. They are expressed as a percent of the full purchase price, or as a percent of your full account. The Federal Reserve Board sets the baseline standards, and in many cases, your firm will impose stricter rules.
There are many types of margin requirements, but they all concern whether the equity in your brokerage account is in correct proportion to the amount of leverage you're using. In other words, margins are a way to assure that there is enough cash behind your borrowing to keep risk in check. Margins apply before you can open an account (minimum margin), before you borrow (initial margin), and to hold on to a position you've purchased (maintenance margin).
Leverage is a tool traders can use to purchase stock shares or futures contracts on credit. In essence, they borrow from their firm to make a trade, without the cash to back it up.
Equity, in this context, is the value of the holdings in your account (including cash) minus the amount you borrow to fund a trade. For example, if your account contains stock futures worth $20,000 and $5,000 in cash, then your total account equity would be $25,000. If you had borrowed $10,000 to acquire those futures, then your total account equity would instead be $15,000.
The two basic margin requirements are known as initial and maintenance margins. The initial margin requirement is the equity needed to enter a position. The Federal Reserve has set this at 50%, so in practice you can borrow twice as much cash as you have to buy or short a stock.
How to Keep Your Account Above Margin
Maintenance margin requirements refer to how much equity you must maintain, as compared to the market value of your holdings. The Financial Industry Regulatory Authority (FINRA) has set this requirement at 25%, but it's common for brokerage firms to raise that requirement to 30% or 40% (or more). Maintenance requirements vary between firms, but they also depend on what type of securities you're trading.
For example, let's say you borrow $10,000 to buy $20,000 worth of stock. If the value of that stock drops to $16,000, then your equity ratio has fallen from 50% to 37.5%. If your firm's maintenance requirements are close to the federal minimum of 25%, then this won't be an issue. But if your firm sets their maintenance requirement at 40%, then you need to add equity to your account. If you don't fulfill this demand in time, your firm could sell the stock to recover the $10,000 it lent you.
Special Rules for Day Traders and Forex Traders
Those who make at least four day trades per week are called and have been marked as "pattern day traders" have a unique margin requirement situation. There are also unique rules that govern forex trading.
Day traders must maintain an equity balance of at least $25,000 in their account at all times. If their account's equity falls below $25,000, then they can't day trade. As long as they maintain that $25,000 minimum, then they may place trades worth up to four times their total maintenance margin excess.
Day traders should ensure that they close out all their trades by the end of the day. Holding a security overnight could apply different margin standards to the trade, which could result in a margin call.
It's common for forex trades to be almost fully margined. In effect, the broker gives you the chance to make trades with money you don't have. The Commodity Futures Trading Commission limits leverage on major currencies to 50:1. Traders should proceed with extreme caution before placing trades with such high levels of leverage. Even the slightest drop in the value of your active trades could wipe out your entire finances.
How to Avoid Margin Calls
In a perfect world, a trader would never have to deal with margin calls. Margin calls only happen when a trade has lost so much money that the exchange or broker wants more money as collateral to allow the trade to go on. If you know what you're doing and manage your trades well enough, you will never allow a trade to become this much of a loser.
Margin calls most often happen to amateur buy-and-hold investors. By failing to get rid of a stock that rapidly falls after purchase, these amateur traders end up having to add more funds to their account, just to maintain a losing position. Savvy traders, on the other hand, know when to cut their losses and liquidate losing positions well before a margin call is required.
Learning when to cut your losses will help avoid margin calls on your account. You can also avoid margin calls by keeping a hefty cash deposit in your account to act as a buffer on any trades, or price dips. These two simple ideas should be part of any trading strategy.