What is a Margin Call?
A margin call happens when an investor’s equity in a margin account falls below the required threshold set by the broker. In a margin account, investors use a combination of their own funds and borrowed money from the broker to purchase securities.
Specifically, a margin call is the broker’s request for the investor to deposit more funds or securities into the account to elevate the equity value and meet the minimum requirement for maintenance.
Typically, a margin call signifies that the securities in the margin account have depreciated in value. When faced with a margin call, the investor must decide whether to inject additional funds or marginable securities into the account or to liquidate some of the assets held.
Key points:
- Margin calls arise when a margin account lacks sufficient funds, often due to unsuccessful trades.
- They involve requests for additional capital or securities to fulfil the maintenance requirement.
- If funds are not deposited, brokers may compel traders to sell assets, regardless of market prices, to meet the margin call.
- Margin calls can also occur when a stock’s price surges, resulting in losses for accounts that have shorted the stock.
- Investors can prevent margin calls by vigilantly monitoring their equity and ensuring they maintain enough funds in their account to exceed the required maintenance level.
Triggers for a Margin Call
A margin call is triggered when the value of securities in a margin account falls below the maintenance margin level set by the broker. This can happen due to a decline in the market value of the securities held or if the initial margin requirement isn’t met for new positions.
Risks of Trading Stocks on Margin
Trading stocks on margin amplifies both potential gains and losses. While leverage can enhance profits, it also exposes investors to increased risks, especially during market downturns. Margin trading involves borrowed funds, leading to higher susceptibility to market fluctuations.
Meeting a Margin Call
When facing a margin call, investors have several options:
Deposit Additional Funds or Securities
The most direct and immediate solution to meet a margin call is injecting further cash or valuable securities directly into the margin account. By augmenting the account’s value, investors fulfil the minimum maintenance margin threshold required by the broker.
Sell Securities
Another strategy involves selling a portion of the securities held within the account. This approach allows investors to convert their assets into the money necessary to fulfil the margin call. However, this method might trigger capital gains or losses, impacting the overall portfolio.
Account Transfers
Alternatively, investors can opt to transfer securities or cash from a separate account to cover the deficit in the margin account. This inter-account transfer ensures compliance with the margin call without the immediate need for external funds or to sell existing holdings.
Each option has its implications. Depositing additional funds maintains the existing portfolio but requires additional capital. Selling securities can impact the overall asset allocation and incur potential taxes. Transferring assets from another account might involve administrative processes and could impact the balance of the transferring account.
Delaying a Margin Call
Delaying compliance with a margin call can be tempting for investors seeking temporary relief from immediate financial obligations. However, delaying compliance isn’t a viable or sustainable solution in the world of margin trading.
Attempting to negotiate with the broker or requesting an extension to meet a margin call might seem like a plausible strategy, but the broker will have predefined margin requirements and protocols in place to manage risk. Failure to comply with a margin call can lead the broker to take swift action to safeguard their interests.
If an investor fails to meet a margin call within the specified timeframe, the broker reserves the right to forcefully sell off securities within the account and restore the account’s balance to the required maintenance margin level. Such actions are typically executed without prior notice, potentially leading to significant losses for the investor, as the broker might sell off securities at unfavourable prices in a distressed market scenario.
Ultimately, delaying compliance with a margin call can exacerbate the situation, leading to adverse consequences such as substantial losses, damaged creditworthiness, and strained relationships with the broker.
Managing Risks Associated with Margin Trading
To mitigate the risks inherent in margin trading, investors can employ several risk management strategies:
- Thorough Research and Analysis: Conduct comprehensive research and analysis before engaging in margin trades to make informed decisions.
- Implement Stop-loss Orders: Set predefined stop-loss orders to limit potential losses and automatically sell securities if they reach a certain predetermined price.
- Avoid Overleveraging: Refrain from excessively leveraging positions beyond a manageable risk level to mitigate potential losses.
- Maintain a Margin Buffer: Keep a margin buffer above the maintenance margin requirement to cushion against sudden market fluctuations and potential margin calls.
How to Cover a Margin Call
Covering a margin call necessitates swift action to correct a shortfall in a margin account. Depositing additional cash or securities directly into the account stands as the primary method to meet this requirement swiftly and raises the account’s value, fulfilling the minimum maintenance margin threshold. Alternatively, investors can opt to sell part of the securities held in the account, with the proceeds used to pay any shortfalls when margin call arrives.
How to Avoid a Margin Call
Investors can move ahead to possibly avoid a margin call and the stress/urgency that comes with it. Monitoring account balances and margin requirements on a consistent basis is paramount. This vigilance ensures a clear understanding of the account’s health and prevents overexposure, allowing investors to maintain a comfortable margin buffer that mitigates the risk of margin calls.
Diversifying also plays a pivotal role in risk management by investing in multiple asset classes. The move reduces vulnerability to the potential decline of a specific asset, thus reducing the likelihood of encountering a significant margin call. This strategy spreads risk, enhancing stability within the portfolio and diminishing the impact of adverse market movements on a single asset.
Example of a Margin Call: Trading Places
In the New York Commodities Exchange scene from the 1983 comedy Trading Places, the antagonists – Duke brothers Randolph (Ralph Bellamy) and Mortimer (Don Ameche) – plot to corner the market on frozen concentrated orange juice (FCOJ) futures. This speculative move echoes the risk-taking nature of margin trading, where investors leverage their positions with borrowed funds.
Similarly, investors in margin trading must be cognisant of the risks and potential consequences. The Dukes used a US Dept of Agriculture report indicating a poor post-winter orange harvest to gain an edge, buying more FCOJ futures to raise the price to as high as US$1.42 per pound, committing all their finances to the effort. What the brothers don’t know is that the document they have is fake.
The main characters, Louis Winthorpe III (Dan Aykroyd) and Billy Ray Valentine (Eddie Murphy), intercepted the Dukes’ bagman and successfully acquired the original report indicating the orange harvest is safe from cold-weather damage. They use the information to start short-selling the futures contracts. After the US Agriculture Secretary makes the report public, the FCOJ futures drop to US$0.29 by the end of trading.
Worse, the exchange officials executed the margin call on the Dukes, who were not able to sell before the end of trading. As they could not pay US$394m immediately, their entire business empire was seized to cover the losses. Louis, Ray, and their friends are able to gain massive wealth from the coup.
In the real world, such practices can lead to severe consequences, including regulatory scrutiny and legal action, which is what happened when the US Congress passed the Dodd–Frank Wall Street Reform and Consumer Protection Act. One provision, Section 746 AKA the “Eddie Murphy rule,” banned insider trading using confidential information.
Conclusion
Margin trading, much like the stock market scene in Trading Places can be a thrilling adventure with potential for great rewards – but investors should be aware of the major risks.
Understanding the mechanics of a margin call, its triggers, and the available strategies to meet or avoid it is paramount for investors engaging in margin trading. While the allure of amplified returns is tempting, the risks associated with margin trading require a disciplined and informed approach.
In the ever-changing landscape of the stock market, investors must learn from the lessons of Trading Places and approach margin trading with a healthy dose of caution, coupled with a commitment to responsible and informed decision-making. By doing so, investors can navigate the complex waters of margin trading and, like the characters in the movie, potentially emerge victorious in the challenging world of high finance.
DISCLAIMER: This article is for informational purposes only and does not replace official stock market advice. AVANTE PARTNERS is not involved with the Australian stock brokerage industry or any entertainment production concerning the stock market. Consult your stockbroker.
