What is a Margin Call? Definition, Calculation, Price Formula & Example
A margin call is a concept associated with trading on a margin (i.e. with borrowed funds). To understand what the margin call is, it would be better to recall the concept of trading on margin first.
Trading on margin is a special type of trading where you trade using both your funds and funds you borrowed from the broker. Brokers that allow this practice enable people to create margin accounts, the funds in which are used for trading on margin. These accounts are closely watched because the broker naturally doesn’t want to lose money.
What exactly is a margin call?
The margin call is basically what happens when a trader is close to losing the money a broker lent them. The provider demands that an investor adds more of their funds to the pool. The ultimatum usually expires after two days, but the exact length varies.
If the demands are not fulfilled, the broker will usually sell some of the assets the investor currently has on the market prematurely until the total value of assets and money in the account goes up to the required level called margin maintenance.
A maintenance level is a tricky number, but its existence shouldn’t be a surprise. Whenever a trader opens up a margin account, they are notified of the current margin maintenance level.
Margin maintenance is the amount of money and value of assets the investor should keep intact at all times. This is what you must remember about the maintenance:
- It is always a percentage of the value of your account, be that assets (their market value is what’s represented) or money.
- The maintenance should be kept in your own funds (called the investor’s equity), the borrowed money doesn’t count.
Let’s draw an example immediately.
Say you borrowed $15,000 from the broker to buy some stock. Naturally, you can’t simply start trading with this money – you have to add some of your money. Your margin maintenance will likely be at 25% if you trade with American brokers because they can’t charge larger maintenance.
So, 25% of your entire account value is basically a minimum amount of your own funds that you can invest. Mind you, it should be in your own money. That’s why to the borrowed $15,000 you also have to add at least $5,000.
So, your margin call formula (when you’ll be deducing it) should include the margin maintenance percentage as well as your equity percentage. The latter shouldn’t be below the former.
At this point in time, the entire value of your account is $20,000, and 25% are your own funds. The 25% of the entire value ($20,000) should be kept in investor’s equity (your own money), and that’s exactly the case.
If you buy some shares worth $20,000, then your account value will now be kept in assets. The purchase has been completed, and your minimal equity (your margin maintenance) has been frozen at $5,000. At the same time, if the price of the stock changes, your investment will suffer, but the borrowed margin will not.
Margin call example
Bearing the previous example in mind, say the price of a stock you bought for $20,000 you had ($5.000 of which are your own) has doubled. The equity part will rise to $10,000, and the margin part will be $30,000.
However, now you can sell the stock, return the money and gain $20,000 ($40,000 – borrowed margin). The profits are 400%. That’s the perks of trading on margin.
However, if the same stock price has dropped by 25%, and you’ll only have $15,000 of the total value in your account – it’s your equity that’s going to suffer. The $5,000 difference will be withdrawn from your part of the investment, and it’ll be $0 total and 0% of the account value.
The borrowed money is intact and can’t be changed. However, your portion can be, and that’s the main problem.
If it happens, that’s when the margin call will be extended to you. You’ll be forced to add money to your margin account until your funds make up ¼ of the whole sum again. That’s the margin call definition.
Ways to manage the margin call
First of all, you shouldn’t take the bare minimum and only invest the amount of equity demanded by the broker. Ideally, you need to invest as much of your own money as possible. Most brokers forbid you to invest more than 100% of the margin they gave you.
Most of the time, your equity will be somewhere between 25% (margin maintenance) and 50% (the maximum you can invest) of the whole value of your account. Whatever the number, after the purchase, it becomes your solid minimal amount, you can’t go below it.
Naturally, you’ll want to have more equity in reserve because if you only have the bare minimum, even if a stock price fluctuates by -1, it will trigger a margin call and you’ll have to add more funds to the pool.
Anyhow, if the margin call has been extended, you have two options in most situations:
- Add at least as much money as the call demands, which will raise your equity part back to the necessary requirement.
- Reduce the margin loan so your current equity portion will rise in proportion to the decreased margin.
When the broker’s demands are fulfilled and the margin call is revoked, you’ll be able to continue your trading. Until then, your activity in its entirety will be frozen.