What Is a Margin Call?
Definition & Examples of a Margin Call
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 experience a margin call must quickly deposit additional cash or securities into their account, or else the brokerage 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 some strategies for avoiding them.
What Is a Margin Call?
A margin call is a warning that your margin account's equity balance has fallen too low and it can no longer satisfy margin requirements. A margin call essentially 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 add equity to your brokerage account. An easy way to do this is to deposit more cash into your account, but you can also transfer stocks or other securities into the account to satisfy this requirement.
Margin calls originally got their name because the brokerage would call the trader on the telephone. Your brokerage may or may not still conduct margin calls via phone call. Your brokerage may also automatically close certain positions after a margin call has been issued.
It's best to check with your brokerage to understand how margin calls will be issued and whether any positions will be automatically closed.
You will typically have a few days to meet the requirements after a margin call has been issued (the exact timeframe depends on your brokerage). If the deadline has passed and you still haven't satisfied the requirements, your brokerage 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 execute at.
Margin requirements—the rules that govern when a margin call is issued—are set by both federal authorities and individual brokerages. Federal authorities set the bare minimum restrictions, and in many cases, your brokerage will impose stricter rules.
There are different 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 (the money you've borrowed to trade).
Equity, in this context, is the value of the holdings in your brokerage account (including cash) minus the amount borrowed 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 required to enter a position. The Federal Reserve has set this requirement at 50%, so you can essentially borrow twice as much cash as you have to buy or short a stock.
Maintenance Margin Requirements
Maintenance margin requirements refer to how much equity you must maintain, relative to the overall market value of your holdings. The Financial Industry Regulatory Authority (FINRA) has set this requirement at 25%, but it's common for brokerages to raise that requirement to 30% or 40% (or more). Maintenance requirements vary between brokerages, but they also depend on what type of securities you're trading.
As an example, consider a scenario in which you borrowed $10,000 to buy $20,000 worth of stock. If the value of that stock then drops to $16,000, then your equity ratio has fallen from 50% to 37.5%. If your brokerage's maintenance requirements are close to the federal minimum of 25%, then this won't be an issue. However, if your brokerage sets their maintenance requirement at 40%, then you need to add equity to your account, or else your brokerage will 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 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 requirements to the trade, potentially resulting in a margin call.
It's common for forex trades to be almost entirely margined. In effect, the broker gives you the opportunity 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 effectively wipe out your entire finances.
Avoiding Margin Calls
In a perfect world, a trader would never experience margin calls. Margin calls are only received when a trade has lost so much money that the exchange or broker wants more money as collateral to allow the trade to continue. A professional trader should be managing their trades well enough that they never allow a trade to become this much of a loser.
Margin calls are most often experienced by amateur buy-and-hold investors. By failing to get rid of a stock that rapidly falls after purchase, these amateur investors must essentially deposit more funds to maintain a losing position. Professional traders typically cut their losses and liquidate losing positions well before a margin call is required.
Learning to properly cut your losses will help avoid margin calls on your account. Another tip is to always keep a hefty cash deposit in your account to act as an equity buffer on any trades. These two simple ideas should be part of any trading strategy.
- A margin call is when a brokerage informs 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 brokerage selling off your positions at will.
- Margin requirements vary by brokerage, account type, trade type, and the securities being traded—it's important to understand the requirements that apply to your situation.