One of the worst things you might face as a trader is a margin call. But, you can prevent a lot of pain by learning more about how margin accounts work. Factor in a little prevention, and you'll save yourself a lot of trouble down the line.
How Does Margin Debt Work?
When you open a margin account with your broker, you tell them that you may want to borrow money from them at some point. You do this by pledging the cash and securities in your account as collateral for the margin loan. Once you borrow the funds to buy securities, the broker can then sell off your other assets if needed to satisfy your margin loan. This is a disaster waiting to happen.
If your account doesn't have enough value to satisfy the margin loan, you must come up with the entire debt balance. That is, you can lose much more than the funds you have in your account. There are dangers to buying stocks and other securities on margin.
Any time you trade on margin, you've introduced the possibility of a margin call. A margin call occurs when the required equity relative to the debt in your account has fallen below certain limits. The broker demands an immediate fix, either by depositing additional funds, liquidating holdings, or both.
Triggering Margin Calls
Your account might have fallen below the regulatory requirements governing margin debt. This can happen due to changes in asset prices or changes by regulators. Federal Reserve Regulation T makes it possible for the nation's central bank to enforce margin debt-to-equity requirements. This is a way to avoid excessive speculation.
For example, current rules state that when dealing with stocks on the New York Stock Exchange, the borrower must have at least 50% equity at the time of purchase. They must also keep 25% equity in their account at all times. If you had $100,000 in an account, you could borrow another $100,000 on margin. This would take your total assets to $200,000—half debt, half equity. You might not face a margin call until your account balance declined by 33.33% to $133,333. At this point, the debt would be 75% of the total account balance.
There are other limits on margin debt. For instance, there is a limit for accounts of less than a certain size (usually $2,000) or when trading so-called penny stocks.
Brokerage Firm Rules
You may also become subject to a margin call if your firm changes its margin policy for your account. Perhaps they no longer think that you are a good risk. Or, maybe it's because of a specific security you own. There are many reasons why they might change their policy. None of these have to be fair or serve your best interests. For instance, many brokerage firms set margin maintenance requirements much higher than the minimum regulatory rules.
Brokers don't want to be on the hook for borrowed money that you can't repay. So, the bigger the equity cushion to absorb losses, the safer it is for them. The margin debt exists at the discretion of the brokerage house. They can demand payment at any time without giving you notice.
When a situation arises in which your account no longer has the equity-to-debt ratio required, the broker issues a margin call.
Getting a Margin Call
A margin call is most often issued these days by placing a large banner on the website when an investor logs in to check their account balance. If the broker is not worried, it may give you time to deposit new cash or securities in your account to raise the equity value.
Otherwise, the broker may begin selling off your holdings to raise cash. The broker is interested in protecting its own financial condition and doesn't want to go after you to collect a debt. As a result, it is under no obligation to give you time to meet a margin call. It does not have to consult you before liquidating assets in your account to cover any margin debt.
You may not get a chance to rectify the situation. When you opened your account, you signed the account agreement that spelled out the margin call ramifications clearly, so you must live with the outcome.
Your broker can decide to sell your highly appreciated securities. This can leave you with big deferred tax liabilities and trigger major capital gains expenses for you. They can also sell your severely undervalued stocks or bonds at the worst moment, locking in your losses.
Not Meeting a Margin Call
The seriousness of a margin call, especially if it leads to debts that you cannot afford to pay, cannot be understated. If you are unable to meet a margin call, and the assets have already been liquidated in your account to repay the debt, you'll find that the remaining balance owed becomes an unsecured debt that is now in default. Among other things, the following are can be potentially affected.
The debt will be reported to credit agencies. This will make it harder to borrow money as it will affect your credit score. Your other lenders may cut off access to their products. For instance, a credit card company may close your account. They may also raise your interest rates to offset the risks.
If you have business loans, you may also find the entire balance owed on those debts. Also, you may find it harder to land a new job as some states allow employers to look at credit histories for new hires.
A universal default may be triggered. You may find your insurance rates on your home, cars, or other policies increasing in states where it is permitted.
The broker may launch a lawsuit against you demanding immediate payment, including legal costs. The remedies available depend on the laws of your state, but they may include forcing you to disclose your entire financial situation under oath, including:
Your bank accounts and other personal property may also be garnished or seized, including putting real estate investments up for sale.
In many cases, the best option may be to raise money however you can and wipe out the debt within days, even if it means selling other assets such as cars or furniture. You may choose to consult as quickly as possible with a bankruptcy attorney. If filing is the right call, they might advise you to do it sooner than later.
In some cases, you might opt to accept the pain of bankruptcy. It can protect the money within your 401(k), 403(b), Roth IRA, or another retirement plan, as they are often beyond the reach of creditors. If you liquidate these accounts to meet a margin call, you'll get hit with ordinary taxes plus an additional 10% penalty tax. If your liquidated IRAs weren't sufficient to pay the entire balance, you might still have to result to bankruptcy.
Avoiding Margin Calls
The best way to avoid margin calls is to open a cash-only account at your brokerage firm. Aside from being a little more inconvenient, it means you can't create margin debt because securities must be fully paid in cash when you buy them. If you want to employ leverage within a cash account, you can still gamble with investments like stock options that are fully paid or 3x leveraged ETFs.
For instance, instead of shorting a stock, you might buy options on the stock instead. Put options have different risks and trade-offs. But, the most you can lose is 100% of the amount you spent on the cost of the puts. You can also decide only to take positions that have a theoretical, maximum loss and keep that amount of money, plus a 10%–20% cushion for interest or other contingencies, in an FDIC-insured bank account or U.S. Treasury bills. That way, you know you can cover the worst-case scenario payment.
Brokers may not give you a chance to meet the margin call. They could liquidate your positions before you've been contacted.
The Bottom Line
You'll find that you get slightly better treatment from a private bank or full-service broker than you would at a discount brokerage. If you had a margin call that was a tiny part of your net worth, they might find a way to avoid having your holdings sold off by giving you a courtesy phone call.
Brokers don't have to notify you, so never assume they will. But, it's possible they don't want to lose a wealthy client who pays a lot of fees over a paltry sum. You won't get a courtesy call from a discount broker, so be careful if you're working on your own.