Borrowers often need money to buy things that cost more than the cash they have on hand, such as homes and cars. Banks and other lenders will provide the money if they trust a borrower will repay the loan, and if the borrower pledges something of value—collateral—to secure the loan.
This also happens in financial markets, when investors borrow from their brokers to buy more securities—typically stocks—that they expect will gain in value. This is called buying on margin. Lending brokers demand collateral—usually the purchased securities—to give them greater assurance their margin loans will be repaid. A rising share price increases the odds that this will be the outcome.
But investments don’t always work out, which is when an investor can get hit with a margin call.
What are margin calls?
A margin call is when a broker notifies an investor that the value of the investment has fallen too low relative to the amount borrowed. The margin call’s purpose is to make the investor quickly put up more cash, or sell some of the purchased shares, to ensure that there’s enough collateral to cover the margin loan.
Federal regulations permit an investor to borrow as much as 50% of the price of purchased securities. The broker will also require that the investor’s cash portion of the investment—the investor’s equity—be maintained at a certain minimum percentage of the securities’ market value. This is called the maintenance margin. It’s the investor’s skin in the game, so to speak. The minimum allowed by regulation is 25%, but brokers may demand a higher maintenance margin, sometimes 30% to 40%.The broker also will charge interest in the margin loan at an annual rate of 2% to 8% of the amount borrowed.
Example of a margin call
Here’s a hypothetical situation illustrating how a margin call might occur:
- An investor has $10,000 in cash and takes out a $10,000 margin loan.
- The investor buys 100 shares of ABC Corp. at $200 each for a total cost of $20,000.
- Maintenance margin is set at 40% of the market value of the ABC investment, or $8,000 at the time the shares are purchased.
- ABC shares fall 25%, to $150, reducing the value of the investment to $15,000.
- The $5,000 decline in the investment’s value is deducted from the investor’s initial equity of $10,000.
- Maintenance margin has declined to 33.3%, which is calculated by dividing the $15,000 value by the investor’s remaining equity, or $5,000, which is expressed as $5,000/$15,000. The broker tells the investor it must be restored to 40%.
Paying a margin call
The investor can satisfy the margin call in one of two ways:
1. Deposit $1,000 in cash to raise the equity to $6,000. The margin would then be:
$6,000/$15,000 = 40%
2. Or, sell ABC shares to reduce the margin loan balance. To determine the required amount of shares, divide the margin deficiency by the 40% margin requirement (in decimal form):
$1,000/0.4 = $2,500
Selling $2,500 of ABC shares reduces the margin loan to $7,500 from $10,000.
The investor’s ABC stake is then valued at:
$5,000 (investor’s equity) + $7,500 (margin loan) = $12,500
And the maintenance margin is restored:
$5,000/$12,5000 = 40%
The reason $2,500 in shares must be sold to fix the margin deficit, when a cash infusion of only $1,000 will do, is because the investor only “owns” 60% of the value of the shares (100% - 40% maintenance margin).
What causes a margin call?
An investor buying shares on margin will want to know how much a stock price can fall before it triggers a margin call. One of two formulas can be used to determine a trigger price:
1. Purchase price per share, times [(1 - initial margin, or 50%) divided by (1 - maintenance margin, or 40%)].
From the ABC example above, the formula looks like this:
$200 x (1 - 0.5/1 - .04), or $200 x 0.8333 = $166.67
In this case, the trigger point occurs when the shares fall from the initial purchase price of $200 to $166,67, a decline of 16.7%.
2. Margin loan amount, divided by (1 - maintenance margin), divided by the number of shares in the purchase.
In the ABC example, this would look like:
$10,000/(1 - 0.4) = $16,666.67
$16,666.67/100 shares = $166.67
So using either formula, the investor buying $20,000 of ABC, using $10,000 margin, should know that when ABC shares trade below $166.67, the broker will issue a margin call.
What happens when you get a margin call?
An investor should find out how soon the margin call must be satisfied, and be prepared to act quickly. When markets are calm, a broker may allow a well-funded investor two to five days to meet a margin call. In volatile markets, the broker may demand a same-day response, or the broker may move unilaterally to sell shares for repayment of the loan.
Consequences of not paying a margin call
Investors who don’t respond quickly to a margin call may face some severe consequences including:
- Distress sale. Based on the terms of a typical margin loan agreement, the broker can sell the investor’s shares without notice, possibly at distressed prices if prices are falling rapidly.
- Seizure of assets. Other accounts and assets of the investor may be seized. The broker’s priority is collecting enough funds to ensure the margin loan is repaid, from whatever sources necessary.
- Legal action. The investor may be sued by the broker if the margin loan isn’t fully repaid.
- Credit rating. Any default on the loan will be reported to credit agencies, and the investor’s credit score will suffer.
Avoiding margin calls
There are a number of steps investors can take to avoid margin calls including:
- Check the margin account daily.
- Know a stock’s trigger price for a margin call.
- Set up price and trend alerts.
- Replenish the cash equity position or sell some of the margined shares before a call is triggered.
- Have other funds or acceptable securities available to satisfy a call.
- Set up strategies to avoid or minimize losses, such as stop-loss orders with a broker.
- Don’t max out the margin. A broker may allow up to 50% initial margin, but a more conservative approach might be 75% cash, 25% margin to buy stock.
The bottom line
Margin is borrowed money from a brokerage firm that used to increase the size of an investor’s share purchases. Like any borrowing to invest, it can boost profits if the stock price rises, or it can exacerbate losses if the price declines.
Buying securities on margin, like all borrowing to invest, is a double-edge sword—it can magnify gains but can also exacerbate losses. Things can go awry quickly in volatile markets, and an investor buying on margin can be required to put up more cash or sell securities at a loss that can exceed the initial investment. And the margin loan must be repaid, with interest.For these reasons, margin accounts may not be suitable for investors who don’t have a high risk tolerance.