Margin calls can be painful for investors trading with borrowed cash. Here, we answer the question "what is a margin call?" and explain why they happen.
Margin Call is a movie that chronicles the early stages of the 2008 financial crisis, where an investment bank faces collapse after taking on debts too large to handle – and has to make some tough choices under pressure to avoid going bankrupt altogether.
While individual investors may not have as many zeros in their account as the fictitious firm in this film, they too can be subject to a margin call – with potential consequences just as serious.
So what exactly is a margin call, and why do they happen?
Trading with borrowed cash can create a margin call. The practice, known as margin trading, involves putting up a modest amount of cash to invest with significantly larger buying power. Or more simply, margin traders borrow money from their brokers. The money they provide up front as well as the underlying investments they buy with borrowed cash are the collateral for that loan.
This investing practice can be quite complex. But without getting into details, let's just say margin trading is always costly because of the interest rates on these loans. It is also often very risky.
A margin call is an event that happens to margin traders where their broker demands more money. This occurs because a margin trader's account is facing significant losses, and the broker fears they won't get repaid on their loan.
Think of it this way: If you invest $10,000 of your own money and lose $7,500… it's very embarrassing, but it's your choice whether to stay the course. And if your personal budget doesn't add up after the losses, it's unfortunate, but ultimately it's your call as to which bills get paid first.
If you had invested $5,000 of your own money and another $5,000 you borrowed from your bank … well, it's not just your money that's gone with that $7,500 loss. The bank is going to want its money back, but your investment portfolio that's now valued at $2,500 doesn't cover the tab – and paying your broker becomes a top priority.
When do margin calls happen?
That previous scenario is actually unlikely to happen, in fact, because your brokerage will demand money before losses ever get that bad. This is because trading platforms have sophisticated systems that measure risk and predict when you're in danger of suffering a big loss. As a result, your broker will almost always demand more money sooner rather than later.
They also demand a minimum amount of investor equity in a portfolio – that is, your own personal skin in the game and not just their loan. Equity percentages vary, but are generally at least 30%.
Let's do some math to show an example of how this would work.
You put up $5,000 of your own money and borrow $5,000 from your broker to make a $10,000 investment. Your investor equity stake is 50% of the $10,000 value.
Now let's say that investment falls to $8,000 in value. The loan is still $5,000, so the losses are not shared equally. Rather, your investor equity takes the hit first and so you only have a $3,000 direct stake – or 37.5% of $8,000.
At this point, your broker may politely warn you are at risk and suggest you deposit more cash. After all, things can change on Wall Street and you're still above their 30% equity threshold.
Unfortunately, things get even worse and the value of your investment keeps drifting lower toward $7,000. Minus their loan, your personal stake would be a mere $2,000 or about 28.5%.
Now things are serious. Since 30% of $7,000 is $2,100, you'll have to put an extra $100 in your account immediately to meet that minimum.
That might not sound terrible. But what if you pony up $100 and the investment keeps falling to $6,000? Well, 30% of $6,000 is $1,800. So you're still behind, and have to come up with even more cash.
If you don't have it, you'll be forced to sell some or all of your portfolio to make up the difference.
(Image credit: Future)
Fundamentally, margin calls happen because of this lack of investor equity in a portfolio. So before you engage in any margin trading, have a full understanding of your broker's structure – including the specifics of margin calls, minimum equity requirements and other fine print.
Jeff Reeves writes about equity markets and exchange-traded funds for Kiplinger. A veteran journalist with extensive capital markets experience, Jeff has written about Wall Street and investing since 2008. His work has appeared in numerous respected finance outlets, including CNBC, the Fox Business Network, the Wall Street Journal digital network, USA Today and CNN Money.
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