Basics of margin calls: An unpleasant flip side of using leverage

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Not the call you were hoping for.

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A margin call is the kind of call no investor or trader wants to get. When you invest or trade in a margin account, you borrow money to buy or sell stocks, futures contracts, or other assets. If the market moves against you past a certain point, your broker will call on you to cough up additional funds to cover your losses. That’s known as a margin call.

The specifics of a margin call vary from asset class to asset class, and your broker might have rules that are more strict than the regulators require. But there are a few basics that cover margin calls in general.

Margin, aka leverage, could be likened to a mechanic’s wrench—a tool investors and traders use with the aim of boosting their buying power and amping up returns. But imagine if that “wrench” slipped from your hand, boomeranged back, and smacked you square in the face. That’s what a margin call might feel like. It’s an unpleasant flip side to margin’s chief benefit—juicing your purchasing power, and thus the potential to profit from an investment.

When you initiate a position in a margin account, you’re required to post “initial” margin—cash or securities that are used as collateral to protect your broker against an adverse price move. Remember: You’re borrowing their money and using it to invest in things that could lose value.

If the value of your position falls below a certain level, your broker will contact you (via phone, text, alert, or another notification) demanding you top up the value of your account. You’ll be asked to deposit cash or securities from outside your account, or sell other securities to raise the level of cash in your account.

Margin calls, and the excess use of margin, have been blamed for numerous financial debacles throughout history, including the 1929 stock market crash. When markets are already flagging, margin calls require investors to sell positions at the worst possible time. This creates a vicious cycle, as margin-call-induced selling sets off other margin calls, requiring those investors to sell securities, and so on.

It’s perhaps the biggest risk of margin trading.

Under the Federal Reserve’s Regulation T, or “Reg T,” investors can borrow up to 50% of the purchase price of securities. That’s the initial margin. Brokerages can establish their own initial margin requirements, but they must be at least as restrictive as Reg T.

Here’s an example: Suppose you have an account with a broker, are approved to trade on margin, and want to buy 100 shares of ABC Inc., trading at $100 per share, which would require a cash outlay of $10,000. Under Reg T, you could use $5,000 of your own cash and borrow the other $5,000 from your broker.

If ABC drops from $100 to $50, for example, the position value would shrink from $10,000 to $5,000. You’ll get a margin call from your broker requiring you to come up with additional funds to close the gap. You’d then have a few options, including depositing the $5,000 in cash, selling other securities to raise cash, or a combination.

Under Reg T, you’d have one “payment period,” or four business days from the trade date, to meet the margin requirement. But your broker has the right to shorten the payment period and may even require you to deposit an amount that exceeds your initial margin.

Again, the broker is loaning you money, and thus has a right to protect their bottom line. The trade was your idea, right?

After you make a trade and deposit that initial margin, there’s a minimum amount of equity that you’re required to maintain in order to keep the position open. That’s called “maintenance margin,” and depending on the agreement between you and your broker, that might be somewhere between 30% and 40% (recall that, under Reg T, your initial margin equity would be 50%).

For example, suppose you take $5,000 in cash in your brokerage account, borrow another $5,000 from your broker, and buy 100 shares of ABC, which is trading at $100, for a total position value of $10,000, and total equity of $5,000 (or 50% of the position value). If your broker has a 30% maintenance margin requirement, that means if your position equity drops to below 30% of the position’s value, you’ll get a margin call.

If ABC shares drop to $60, the overall value of the position shrinks to $6,000. The amount you borrowed, $5,000, remains the same. Your equity is now just $1,000, which is ($1,000/$6,000) = 16.67% equity. That’s below the $1,800 equity required (30% of $6,000 is $1,800).

In this instance, you’d get a margin call saying you need to add $800 to bring your account up to that 30% maintenance level.

Maintenance margins exist in futures trading, too. But it works a bit differently. When you buy a stock on margin, the stock is in your margin account and can be used as collateral against your margin loan. But a futures contract is an agreement to make or accept delivery of an underlying asset—barrels of crude oil, shares in a stock index, or a bunch of Treasury bonds.

Because there’s no real asset in your account, just an agreement, there’s no collateral to back up your account aside from your initial margin (called a “performance bond,” which is sort of a good-faith deposit toward any adverse price movement between now and when a contract is liquidated). With a futures contract, if the equity in your account falls below the maintenance margin level, you’ll get a margin call telling you to add money to your account all the way up to the initial margin level.

For example, one Micro WTI Crude Oil futures contract (listed on the NYMEX division of CME Group) represents 100 barrels of the U.S. benchmark West Texas Intermediate grade crude. Trading this contract requires an initial margin of, say, $930 (about 12.4% of the contract’s notional value as of late 2022) and a maintenance margin of, say, $750.

Suppose crude oil falls $2 per barrel, from $80 to $78. Your 100-barrel contract would fall by $200, taking the value of your performance bond to $730—below the maintenance margin level of $750. So your broker would issue a margin call, requiring you to top up your account to the initial margin level of $930.

If you’re thinking about trading on margin, you should first consider the prospect of getting a margin call, how you’d handle it, and whether you have the wherewithal and resources to make good on your obligations.

And understand your risk tolerance, because trading on margin poses unique risks compared with trading with a cash account. If you do use margin, make sure you keep a close eye on the markets, your position, and your broker’s maintenance margin requirements.

If you get a margin call, it may be the market’s way of sending you a personal message: You were wrong about this one, and maybe it’s time to cut your losses and not throw good money after bad.

As the Financial Industry Regulatory Authority (FINRA) puts it: “Know the rules—and stay abreast of market conditions to monitor when you might be getting close to a margin call. You might not be able to avoid the call, but at least it won’t come as a big surprise.”