A margin call is an action required by a brokerage when an investor uses margin to secure a position and then the value of the position falls so that the account fails to meet the account’s margin maintenance requirement.
Typically, to be able to trade using margin you need: at least $2,000 in cash equity and a minimum of 30% of the total equity in your account needs to be your own.
As per Regulation T set forth by the Federal Reserve Board, you can only use margin to purchase up to 50% of a stock’s purchase price.
The brokerage will lend you $50 if the stock is $100. And if you want to buy 10 shares at once, they then lend $500.
Example of using Margin and receiving a Margin Call:
You have $20,000 of your own money. You then use $20,000 of borrowed margin money to take a $40,000 position in a particular stock.
Right now your personal equity is 50% ($20,000/$40,000) of the total value of the position. This is above the 30% margin maintenance requirement — so everything is alright.
But, lets say that the value of the stock falls 35%.
This now puts the position at a value of $26,000. Since you borrowed $20,000 that borrowed equity value stays the same (you still owe $20,000). The new current value of your own equity is reduced to only $6,000.
This will trigger a margin call because the investor’s equity has fallen under the margin maintenance value of 30%. To calculate investor equity for a position:
(Current Value of the Security – Borrowed: aka Margin Funds) / (Current Value of the Security)
In our situation lets fill in the Numbers:
($26,000 – $20,000) / ($26,000) = .23 or 23%
Since the maintenance value of the account is 30%, the money needed to maintain the margin is calculated as $26,000*30% = $7,800.
Since your own equity is only $6000, ($7,800-$6,000) $1,800 is the value of the margin call.
To solve the margin call you have two choices:
- You need to deposit that amount in cash ($1,800).
- Sell part of the position so that the value of borrowed margin is less and you meet the 30% margin requirement.
Otherwise, the brokerage can and will sell the position for you. This is because they want to be able to secure the money that they lent to you on margin. You will not have long to add cash or sell the position yourself, so do it quickly.
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