Buying on margin involves taking out a partial loan from a stockbroker in order to cover a larger investment than your capital could directly cover.
A margin call most often occurs when the amount of actual capital the investor has drops below a set percent of the total investment.
A margin call may also be triggered if the stockbroker changes his minimum margin requirement — the absolute minimum percentage of the total investment that you must have in direct equity.
Below are some examples that will best demonstrate two circumstances in which a margin call is likely to occur:
A. Let us assume that you go through your stockbroker to purchase 100,000 worth of stocks.
We’ll say that you borrowed 50,000 from your stockbroker on margin to purchase the stocks, and invested 50,000 of your own capital.
After a particularly poor month of performance, the stock you initially invested in is now worth only 75,000.
This leaves your equity at 25,000, which we can determine by taking the current value of 75,000 and deducting the loan value of 50,000.
If your stockbroker’s minimum margin requirement is 30%, you will still be fine, as the minimum margin requirement in your case would be 30% of 75,000, or 22,500.
If, however, the value of the stock drops again the next week to 60,000, then your equity will only be 10,000.
At this point, your stockbroker will put out a margin call, and you will be forced to raise at least an additional 8,000.
You might raise the money to meet the margin call by selling off a portion of the stock you have invested in, by taking out an additional loan from another source, or by replenishing your equity pool with your own assets.
B.The second scenario in which a margin call might occur has to do with the brokerage itself, rather than the performance of the market.
Let us assume the same situation as before, in which you have purchased 100,000 worth of stocks with 50,000 in equity.
The same initial downturn occurs, leaving you with 25,000 in equity on a 75,000 investment.
This same brokerage has a minimum margin requirement of 30%, so they have no need to issue a margin call.
Occasionally, however, because of the swinging market or internal factors, a brokerage may decide to adjust their minimum margin requirements slightly.
If your brokerage were to raise their minimum margin requirement to 35%, the minimum equity in your case would be 26,250, so you would be issued a margin call and be forced to raise an additional 1,250.
A margin call — as long you can afford it (!) — is not a big deal in the financial world, and it does not reflect poorly on an investor to be subject to one.
Margin calls are simply a part of buying on margin, and while some people choose to keep their invested equity well above the minimum margin requirements to avoid a margin call …
Others keep themselves continuously invested at exactly the minimum, prompting a margin call every time the market takes a downturn.