Marge call

What Is a Margin Call?

A margin call is a demand from a brokerage firm for an investor to deposit additional funds or securities into their margin account to bring the account's equity back up to a minimum required level. This critical event falls under the broader umbrella of risk management within investment finance, serving as a safeguard for brokers who extend credit for leveraged trades. Margin calls occur when the value of securities held on margin declines, increasing the investor's leverage and the broker's exposure to potential losses.

History and Origin

The practice of borrowing to finance securities purchases, known as margin trading, has been a feature of financial markets for centuries. However, its regulation and the concept of a "margin call" gained prominence particularly after the devastating Wall Street Crash of 1929. During the speculative frenzy leading up to the crash, investors commonly purchased stocks with very low initial margin requirements, sometimes putting down as little as 10% of the purchase price. As stock prices plummeted in October 1929, brokers issued unprecedented numbers of margin calls, demanding immediate repayment of loans. Many investors, unable to meet these demands, were forced to sell their holdings, which further exacerbated the market's decline in a cascading effect.⁸,⁷

This event highlighted the systemic risks of unregulated margin trading. In response, the U.S. Congress passed the Securities Exchange Act of 1934, granting the Federal Reserve the authority to set initial margin requirements. The regulation aimed to prevent excessive speculation and enhance financial stability. Over time, regulatory bodies like the Financial Industry Regulatory Authority (FINRA) have established detailed rules, such as FINRA Rule 4210, which govern the ongoing maintenance of margin accounts and the conditions under which a margin call must be issued.⁶,⁵

Key Takeaways

• A margin call is a demand from a broker for an investor to add funds or collateral to a margin account.
• It is triggered when the equity in a margin account falls below the maintenance margin requirement.
• Failure to meet a margin call can result in the forced liquidation of securities in the account by the brokerage firm.
• Margin calls are a critical component of risk management for both brokers and investors in leveraged trading.
• Historically, margin calls have played a role in exacerbating market downturns, notably during the 1929 stock market crash.

Formula and Calculation

A margin call is triggered when the equity in an investor's margin account falls below the maintenance margin requirement, which is typically a percentage of the current market value of the securities held.

The equity in a margin account is calculated as:

The maintenance margin requirement is typically set as a percentage (e.g., 25% or 30%) of the current market value. A margin call is issued when:

For example, if an investor purchases $10,000 worth of stock with $5,000 of their own money (initial margin) and borrows $5,000 from the broker, and the maintenance margin requirement is 25%:

• Initial market value = $10,000
• Amount borrowed = $5,000
• Initial equity = $10,000 - $5,000 = $5,000

The maintenance margin threshold is 25% of the current market value. Let 'P' be the price per share and 'N' be the number of shares.

The margin call is triggered when:

Solving for P:

This calculation helps determine the price point at which a margin call would occur, highlighting the sensitivity of leveraged positions to price movements.

Interpreting the Margin Call

Receiving a margin call indicates that the investor's leveraged position has deteriorated significantly, and the buffer against further losses—provided by their own equity—is insufficient according to the brokerage firm's or regulatory body's rules. It signals increased market risk for the investor's portfolio. The call demands immediate action: either depositing more cash or eligible securities to restore the equity-to-loan ratio, or selling off existing positions to reduce the borrowed amount. Failure to meet a margin call can result in the broker forcibly selling the investor's assets, often without prior notice, to cover the deficit. This forced selling can lead to substantial, and sometimes irreversible, losses.

Hypothetical Example

Consider an investor, Sarah, who buys 200 shares of XYZ Corp. at $100 per share, totaling $20,000. She uses a margin account, paying $10,000 of her own cash and borrowing $10,000 from her broker. The broker has a maintenance margin requirement of 30%.

• Initial Purchase:

  • Total Value: 200 shares * $100/share = $20,000
  • Borrowed Amount: $10,000
  • Equity: $20,000 - $10,000 = $10,000

• Maintenance Margin Calculation:

  • The maintenance margin percentage is 30%.
  • To find the price at which a margin call occurs, we set the equity equal to 30% of the current market value:
    ( (200 \times P) - $10,000 = 0.30 \times (200 \times P) )
    ( 200P - $10,000 = 60P )
    ( 140P = $10,000 )
    ( P \approx $71.43 )

If the price of XYZ Corp. stock falls to $71.43 per share, Sarah's account equity would be:

• Current Value: 200 shares * $71.43/share = $14,286
• Equity: $14,286 - $10,000 = $4,286
• Maintenance Margin Required: 0.30 * $14,286 = $4,285.80 (approximately $4,286)

At this point, her equity ($4,286) just meets the maintenance margin requirement. If the stock drops even slightly below $71.43, say to $70 per share, her equity would be $14,000 - $10,000 = $4,000, while the maintenance margin required would be $4,200 (30% of $14,000). Since her equity ($4,000) is now less than the required maintenance margin ($4,200), Sarah would receive a margin call. She would need to deposit an additional $200 ($4,200 - $4,000) or sell some shares to cover the deficit and avoid forced liquidation of her financial instruments.

Practical Applications

Margin calls are an integral part of operations in various segments of the financial markets where collateral is used to secure borrowed funds.

• Retail Brokerage: For individual investors engaged in margin trading, margin calls are a direct mechanism by which brokers protect their loans against adverse price movements in the underlying assets. These calls ensure that brokers can mitigate their credit risk from client defaults. Regulations, such as those enforced by FINRA in the U.S., dictate the minimum maintenance margin requirements and the procedures brokers must follow when issuing calls.
• ⁴ Futures and Derivatives Markets: In futures and options trading, margin is a performance bond, and margin calls are routine, often daily, adjustments to reflect changes in the value of the positions (variation margin). These markets are highly leveraged, and timely meeting of margin calls is crucial for market integrity and to prevent systemic failures.
• Institutional Trading: Large financial institutions engaging in over-the-counter (OTC) derivatives or repurchase agreements (repos) also face margin calls. These are often bilaterally negotiated, but the principle remains the same: collateral is adjusted to reflect counterparty risk and market value changes. The size and frequency of these calls can have significant implications for a firm's liquidity management, especially during periods of high volatility.

Limitations and Criticisms

While designed as a risk control measure, margin calls themselves can contribute to systemic instability during periods of extreme market stress. This phenomenon is often referred to as "margin procyclicality."

• Amplifying Downturns: When markets experience rapid declines, widespread margin calls can force investors to sell assets, regardless of their long-term investment strategy. This forced selling, often into a falling market, can accelerate price declines, creating a negative feedback loop that exacerbates the downturn. This was evident during the 2008 financial crisis and the market turmoil in early 2020.,
• ^{3 2} Liquidity Strain: Forcing investors to meet margin calls in illiquid markets can create severe liquidity strains. If an investor cannot quickly raise cash, they might be forced to sell other, unrelated assets, potentially spreading financial contagion across different market segments.
• Disproportionate Impact on Smaller Investors: Smaller, less diversified investors may find it harder to meet sudden margin calls compared to institutional players with deeper pockets or broader access to liquidity. This can lead to rapid and complete loss of their investment.
• Behavioral Impact: The fear of a margin call can influence investor behavior, potentially leading to premature liquidation of positions or avoidance of otherwise sound leveraged strategies, even when the underlying investment thesis remains strong.

Regulators and academics continue to study the impact of margin requirements and the procyclical nature of margin calls, seeking to balance risk mitigation with the potential for market destabilization.

##¹ Margin Call vs. Liquidation

A margin call is a notification or demand for an investor to deposit additional funds or securities. It is a warning that the equity in their margin account has fallen below the required maintenance level. The investor still has an opportunity to rectify the situation.

Liquidation, in this context, is the action taken by the brokerage firm if the investor fails to meet the margin call. It involves the forced selling of the securities or other assets held in the margin account to cover the deficit. This happens typically within a short timeframe (e.g., a few days, or even immediately in volatile markets), and the broker usually has the discretion to choose which assets to sell to satisfy the margin requirements. While a margin call presents a choice to the investor, liquidation is a consequence of failing to act on that choice.

FAQs

What happens if I don't meet a margin call?

If you do not meet a margin call within the specified timeframe, your brokerage firm has the right to sell any of the securities in your margin account, without prior notice, to bring your account back to the required maintenance margin level. This forced selling can lead to substantial losses.

How quickly do I have to meet a margin call?

The timeframe for meeting a margin call can vary. For intraday margin calls, you might need to deposit funds or sell securities on the same day. For end-of-day calls, brokers typically give a few business days. However, brokers can liquidate positions at any time if the account falls below the minimum maintenance margin, especially in highly volatile markets.

Can a margin call result in losing more than my initial investment?

Yes, it is possible. If the market value of the leveraged securities declines rapidly and significantly, the losses can exceed your initial cash investment, leaving you owing money to the brokerage firm even after all the securities in your account have been sold. This highlights the inherent risks of using leverage.

Does a margin call mean my investment strategy was wrong?

Not necessarily. A margin call is triggered by a decline in the value of your leveraged positions, which can be due to market volatility or specific news related to your holdings, not solely due to a flawed strategy. However, it does signal that the level of risk in your account is no longer acceptable by the broker's standards.

How can I avoid a margin call?

To avoid a margin call, you can:

• Maintain a higher equity buffer in your margin account than the minimum maintenance requirement.
• Monitor your positions closely, especially in volatile markets.
• Reduce your leverage by paying down your margin loan or selling some of your leveraged positions before the equity drops too low.
• Diversify your portfolio to mitigate concentrated losses.