Whoever has traded or invested in the stock market knows the value of an opportunity and that it shouldn’t be missed. Trading on margin helps you in making the most of such opportunities. It doesn’t let you miss a golden opportunity just because you are low on funds, rather it allows you to buy stocks and make investments by borrowing money. However, just like every other facility, it too comes with a challenge, which is a margin call. Let’s understand more about what it is and why it is considered a challenge.
What is a margin call?
Before we delve into what a margin call is, let’s understand what margin and buying on margin is. When you open a margin account with brokers, it allows you to purchase securities like stocks, bonds, and ETFs using your own money and the money borrowed from your broker. This borrowed money is called a margin.
Thus, the concept of buying securities from money lent by the broker is well-known as buying on margin. It allows you to trade more than you otherwise would be able to using your available funds. However, when you buy on margin, you need to maintain a maintenance margin (explained later) as specified by the exchange. When the margin balance in your account falls below this maintenance margin, a margin call occurs.
Let’s understand what is maintenance margin?
To better understand when a margin call occurs and why it is important, you need to know what a maintenance margin is. The Financial Industry Regulatory Authority (FINRA) has asked brokerage firms to set maintenance on all the margin accounts, currently, it is 25%. This requirement is known as the maintenance margin and specifies the minimum percentage of investments you must wholly own in your margin trading account at all times. It means you have to own outright at least 25% of the securities (current value) available in your margin account. The main objective of FINRA behind raising this requirement is to prevent you from defaulting on loans.
When does a margin call happen?
A margin call occurs when the value of your margin account falls below the maintenance margin set by the exchange. The value of your margin falls when the value of the securities you are holding in your margin account declines. Another rare reason which might lead to this decline is if the exchange increases its maintenance requirement.
Let’s understand this with an example. If you have added ₹10,000 funds to your margin account and borrowed ₹10,000, you could purchase securities worth ₹20,000. Now, if the market value of your investment drops down to ₹11,000, your maintenance margin would be ₹1,000 (The current value of the securities – the amount you owe to your broker). Consider the minimum maintenance margin requirement to be 25%; thus, you would need to maintain ₹2,750 as a margin. In this scenario, you are short of ₹1,750 (₹2,750 – ₹1,000), so your broker might issue a margin call requesting you to either deposit funds or sell securities to make up for the difference.
Let’s understand this with an example. If the user is long on Nifty at level of 17800, total margin required is ₹107500 out of which lets assume the user has given ₹57500 as cash (ledger balance) and ₹50000 as non-cash collateral. Now let’s assume next day Nifty has fallen by 200 points, MTM requirement will be 200*50 i.e. ₹10000 and revised margin on Nifty contract is ₹106750, assuming no change in non-cash collateral, margin call will be issued for ₹9250 {106750 – (57500-10000)-50000}.
Another example – If the user is long on Nifty at level of 17800, total margin required is ₹107500 which lets assume the user has given ₹57500 as cash (ledger balance) and ₹50000 as non-cash collateral. Assuming that the rest of the things are constant but exchange disallowed one of securities valuing ₹15000 given by client as collateral. This will reduce collateral value by ₹15000 and margin call will be issued for ₹15000.
How to cover a margin call?
To satisfy a margin call or a maintenance margin requirement, you can do either of the following things.
- Deposit additional funds into your account
- Transfer additional securities into your account
- Sell securities you are holding
How can you avoid margin call?
If you do not own a margin account, you do not have to worry about the margin call. However, if you do own a margin account, you can do the following things to avoid a margin call.
1. Have additional cash on hand
Rather than investing all your money, keep some added cash to your account to avoid a margin call. This is considered a good option as cash offers a stable value and will remain constant unlike the value of securities that fluctuates.
2. Limit volatility by diversifying your portfolio
As an investor, you have multiple options such as stocks, bonds, commodities, and derivatives to choose from. You can diversify your portfolio by investing in different types of securities. Diversification will help limit the chances of plunging below the maintenance margin that might trigger a margin call quickly.
3. Monitor your account regularly
Even though you don’t need to constantly monitor your portfolio, if you have a margin account, you are going to want to track it daily. It will help you stay aware of whether you are close to the maintenance margin. So that you can take necessary actions immediately.
4. Set your own limit
To effectively avoid a margin call, you can determine your own maintenance margin over and above the exchange. Once your account has reached that limit, you can deposit additional cash to avoid a margin call. This way you will be able to prevent yourself from selling any securities in a hurry to fulfill maintenance requirements.
Conclusion
A margin call is initiated by your broker when the maintenance margin requirement in your account falls below the limit set. You can fulfill your maintenance margin requirement either by adding additional cash or by selling existing securities. Apart from that, you can take necessary steps like setting your own limit, constantly monitoring your account, keeping additional cash in the account, or diversifying your portfolio, to avoid getting a margin call from your broker.
