A margin call happens when a brokerage firm asks the investor to deposit more cash to meet a required minimum balance. To have a better understanding of a margin call, you’ll first have to understand how margin accounts work.
Buying on Margin
If you don’t have all the money to invest in a certain amount of stock, or you don’t want to put all your money in the stock, you can borrow from your broker dealer to purchase the stock. This is known as buying on margin. You pay for part of the stock purchase, the brokerage firm loans you the remainder, leveraging the securities as collateral and then charges you interest on the loan. You’ll need a margin account to buy stocks on margin. To open the account, you’ll at least need to provide your signature and at least $2,000 of your own cash or securities. Some brokerages may require you to deposit more than $2,000. Once your account is opened, the brokerage gives you essentially a credit line that you can use to invest.
Ups and Downs of Margin Buying
Buying on margin can be profitable. When the stock price rises, you earn money, hopefully enough to repay the brokerage firm what you borrowed, plus the interest they’ve charged. The benefit is that you were able to do it without putting up 100% of your own funds. However, if the stock price decreases, not only will you lose what you invested, you’ll also have to pay back what you’ve borrowed plus the interest. Failing to repay what you borrowed, even in a loss situation, can prevent you from opening another margin account.
Maintenance Requirement and Margin Call
When you buy a stock on margin, you’re required to have at least 25% equity in your securities at all times. That means, the amount of cash and securities you’ve contributed to the investment should be at least 25% of the total market value of the security. The brokerage firm may have a higher requirement, e.g. 30% or 40%. If your equity falls below the minimum amount, the brokerage firm will make a margin call for you to deposit more cash to bring up your equity.
For example, let’s say you purchased $10,000 of securities. You put up $5,000 of your own cash and borrowed $5,000. If the market value drops to $8,000, your equity would drop to $3,000. If the firm’s maintenance requirement is only 25%, you’d still have enough equity. But, if the maintenance requirement is 40%, the firm would issue a margin call for $1,000 to bring your equity up to the minimum requirement. You’ll generally have two to five business days to meet the margin call.
If you can’t meet the margin call, the firm will sell some of the security to bring up your equity. Some firms can sell the security without first giving you a margin call. For example, the brokerage firm may sell some or all of your securities before the five days have elapsed. This often happens if the market continues to decline. The firm sells securities to prevent further losses. Continuing to monitor your investment performance and making deposits before the margin call will keep you from facing a sell out. If the security sale doesn’t satisfy the outstanding loan, the broker will ask you to pay the remaining amount.
Failing to pay the outstanding balance may prevent you from opening another margin account, even at another brokerage firm.
Margin purchases also have an initial margin requirement. While the Federal Reserve Board sets the minimum initial margin at 50%, the brokerage firm may require you to put up an additional percentage. A Federal call is a special type of margin call that’s issued when your initial investment is below 50% of the market value of the security. Check with your broker dealer for their particular margin requirements.