What Are Margin Calls?
A margin call is a demand from a brokerage firm to an investor to deposit additional funds or sell securities to bring their brokerage account up to the required maintenance margin level. This financial event primarily occurs in the context of leverage and falls under the broader financial category of risk management in investment. When an investor buys securities on margin, they use borrowed funds from their broker, with the purchased securities serving as collateral for the loan. If the market value of these securities declines, the investor's equity in the account may fall below the broker's minimum requirement, triggering a margin call.
History and Origin
The practice of buying securities with borrowed money, and consequently the concept of margin calls, has a long history in financial markets. Early forms of leverage can be traced back to ancient times with merchants borrowing funds for trade. However, the widespread use of margin in modern financial markets became prominent in the early 20th century. During the 1920s, it was common for investors to buy stocks with as little as 10% of their own funds, borrowing the rest. This high degree of leverage significantly contributed to the severity of the 1929 stock market crash. As stock prices plummeted, investors received numerous margin calls. Many were unable to meet these demands, leading brokers to liquidate their positions, which in turn drove prices even lower and exacerbated the market decline.5,4
Following this painful lesson, regulatory bodies stepped in. The Federal Reserve Board, under the Securities Exchange Act of 1934, gained authority to regulate margin requirements. This led to the creation of Regulation T, which set initial margin requirements and established stricter rules for borrowing money to buy securities. Since 1974, the margin requirement has generally been set at 50%, a significant change from the largely unregulated environment prior to 1929.3
Key Takeaways
- A margin call is a broker's demand for additional funds or securities when an investor's margin account equity falls below the maintenance margin requirement.
- It is triggered by adverse price movements in the leveraged securities, increasing the risk for both the investor and the broker.
- Failure to meet a margin call typically results in the forced sale of securities in the investor's account to cover the deficit.
- Margin calls highlight the amplified risks associated with using leverage in investment strategies.
- Regulations like the Federal Reserve's Regulation T and FINRA rules govern margin trading to mitigate systemic risk.
Formula and Calculation
A margin call is triggered when the investor's equity in the margin account falls below the maintenance margin percentage set by the broker. The equity in a margin account is calculated as:
The percentage of equity in the account is then:
A margin call occurs when:
The amount of money needed to meet a margin call is the difference between the current equity and the equity required to bring the account back up to the maintenance margin level, or sometimes even the initial margin level, depending on the broker's policy.
Interpreting Margin Calls
Receiving a margin call is a critical signal that an investor's leveraged portfolio is facing significant losses due to unfavorable market movements. It indicates that the value of the securities held on margin has declined to a point where the borrowed funds are no longer adequately collateralized. Investors must interpret a margin call as an urgent demand requiring immediate action, typically by depositing additional cash or marketable securities, or by liquidating some positions to reduce the debit balance. Ignoring a margin call or failing to meet it in time will result in the broker taking action, often leading to the forced sale of assets at potentially unfavorable prices, further locking in losses. This underscores the importance of understanding the risks associated with capital management in leveraged accounts.
Hypothetical Example
Consider an investor, Sarah, who buys 1,000 shares of Company X at $50 per share using a margin account. The total value of her position is $50,000. Her broker requires an initial margin of 50% and a maintenance margin of 30%.
- Initial Investment: Sarah puts up $25,000 (50% of $50,000), and her broker lends her the remaining $25,000.
- Debit Balance: $25,000
- Initial Equity: $25,000
Now, imagine Company X's stock price drops to $35 per share due to unexpected negative news.
- New Market Value: 1,000 shares * $35/share = $35,000
- New Equity: $35,000 (Market Value) - $25,000 (Debit Balance) = $10,000
- New Margin Percentage: ($10,000 / $35,000) * 100% = 28.57%
Since Sarah's new margin percentage (28.57%) is below the maintenance margin requirement of 30%, her broker issues a margin call. To bring her account back to the 30% maintenance margin, the equity needs to be 30% of the current market value, or $10,500 (30% of $35,000). She needs to deposit an additional $500 ($10,500 - $10,000) to meet the call. If she fails to do so, the broker will sell some of her shares to cover the deficit, potentially without prior notice.
Practical Applications
Margin calls are a critical component of risk management for both investors and brokerage firms engaged in leveraged trading, including positions in common stocks, options, and certain derivatives. For investors, understanding the mechanics of a margin call is crucial for managing the amplified risks associated with borrowing to invest. It serves as an immediate alert to a deteriorating position, forcing a decision to either inject more capital or reduce exposure.
From a regulatory standpoint, margin requirements and the enforcement of margin calls are vital for maintaining market stability and protecting brokers from excessive credit risk. Regulatory bodies, such as the Financial Industry Regulatory Authority (FINRA), establish rules governing margin accounts. For example, FINRA Rule 4210 outlines margin requirements for various securities, defining minimum equity levels and maintenance margin percentages.2 These rules aim to prevent excessive speculation and reduce the likelihood of widespread defaults that could trigger systemic issues in the financial system.
Historically, margin calls have played a significant role in major market events, such as the cascading liquidations seen during the Archegos Capital Management collapse in 2021. The failure of Archegos to meet its margin calls led to its prime brokers liquidating massive positions, causing billions in losses for the banks involved and highlighting the substantial risks associated with highly leveraged portfolios and rapid market volatility.1
Limitations and Criticisms
While margin calls are a vital risk management tool, they are not without limitations or criticisms. One primary concern is that they can exacerbate market downturns. During periods of high volatility and declining prices, widespread margin calls can lead to forced selling, creating a self-reinforcing downward spiral as liquidations drive prices even lower. This can impact overall market liquidity and contribute to broader financial instability.
Another criticism revolves around the sudden and often unforgiving nature of a margin call. Investors typically have a limited timeframe, often just a few days or even hours, to meet the demand. If they cannot, the broker has the right to sell assets without prior consultation, potentially at unfavorable prices, to cover the shortfall. This can result in larger losses for the investor than if they had been given more time or control over the liquidation process. The amplified risk of using leverage means that a relatively small percentage drop in the underlying asset's price can lead to a substantial percentage loss of the investor's own equity. The Securities and Exchange Commission (SEC) provides investor alerts that highlight these risks, emphasizing that investors can lose more money than initially invested and that brokers can force sales without notifying the client in advance.
Margin Calls vs. Forced Liquidation
Although often used interchangeably in general conversation, "margin calls" and "forced liquidation" represent distinct stages within the process of managing a leveraged position under stress. A margin call is a notification from a broker to an investor. It is a demand for additional collateral (cash or securities) to restore the equity in a margin account to the required maintenance level. The investor still has the opportunity to cure the deficit.
Forced liquidation, on the other hand, is the action taken by the broker if the investor fails to meet the margin call within the specified timeframe. In this scenario, the broker, to protect their loan, sells the securities held in the investor's account without further consent from the investor, until the account's equity once again meets or exceeds the maintenance margin requirement. While a margin call precedes forced liquidation, forced liquidation is the direct consequence of not responding to a margin call.
FAQs
What happens if I receive a margin call?
If you receive a margin call, your broker requires you to deposit additional funds or marketable securities into your account to bring your account's equity back up to the required maintenance margin level. You typically have a limited amount of time to meet this demand.
Can I lose more money than I invested with margin trading?
Yes, it is possible to lose more money than your initial investment when trading on leverage. If the value of your securities falls significantly and rapidly, your losses can exceed your initial capital, potentially leaving you owing money to your broker even after your positions are liquidated.
How can I avoid a margin call?
To avoid a margin call, you can maintain a higher equity cushion in your brokerage account than the minimum required. Monitoring your positions closely, especially in volatile markets, and promptly adding funds or reducing leveraged positions before they trigger a call are also effective strategies.
Are margin calls common?
Margin calls become more common during periods of high market volatility or significant market downturns, as these conditions increase the likelihood of leveraged positions falling below their maintenance margin requirements.