- A margin call is a demand from a broker for additional funds when an investor's margin account falls below a certain threshold.
- It is triggered by a decrease in the value of the investor's positions.
- Failure to meet a margin call can result in the broker liquidating the investor's positions.
Understanding margin calls
Imagine you're playing a game where you borrow money to make trades. If things don't go as planned and your account value drops too much, the game pauses, and you're asked to put in more money. This pause and demand for additional funds is what we call a margin call.
How does a margin call work?
1. Margin account and equity
When you open a margin account, you can borrow money from your broker to invest. The broker sets a minimum equity requirement, which is the percentage of your own funds that must be maintained in the account. For example, if the requirement is 30% and you have £10,000 worth of investments, you must have at least £3,000 (30% of £10,000) of your own money in the account.
2. Falling below the threshold
If the value of your investments declines and your equity falls below the minimum requirement, a margin call is triggered. The broker will notify you and request that you deposit additional funds to bring your equity back up to the required level. This is to ensure that you have enough cushion to cover potential losses.
3. Liquidation of positions
If you fail to meet a margin call, the broker may take action to protect their interests. They can liquidate some or all of your positions, selling your investments to recover the money owed. This can result in losses and may prevent you from participating in potential market recoveries.
Margin calls in the real world
Let's imagine you have a margin account with a broker and decide to trade on margin. You deposit £5,000 of your own funds into the account and have a margin requirement of 40%, meaning you can borrow up to 60% of the value of your investments.
1. Trading on margin
You decide to buy £10,000 worth of shares in a company using borrowed funds. Initially, you contribute £5,000 (40% of £10,000) of your own money, while the remaining £5,000 is borrowed from the broker.
2. Market decline and margin call
Unfortunately, the market experiences a downturn, and the value of your shares decreases by 20%. As a result, the value of your investment is now £8,000 (£10,000 - 20%). However, your equity in the account has fallen to £3,000 (£8,000 - £5,000), which is below the minimum requirement of £4,000 (40% of £10,000). A margin call is triggered.
3. Responding to the margin call
Upon receiving the margin call, you have a few options. You can deposit additional funds into the account to bring your equity back up to the required level. Alternatively, you can choose to sell some of your shares to increase your equity. Failure to meet the margin call may result in the broker liquidating some or all of your positions to cover the shortfall.
Final thoughts on margin calls
A margin call is a demand from a broker for additional funds when an investor's margin account falls below a certain threshold. It is triggered by a decrease in the value of the investor's positions. Understanding margin calls is important for investors who trade on margin to manage their risk effectively and avoid potential losses. Always monitor your positions and ensure you have sufficient funds to meet any margin calls that may arise.