When an investor’s account value drops below a predetermined threshold, called the maintenance margin, a broker or trading platform may issue a margin call, requesting that the investor deposit extra funds or securities into the account. This usually occurs in a margin account, when the investor uses the stocks they have purchased as collateral to borrow money from the broker to purchase other securities.
Detailed Definition:
- Margin Account: With a margin account, traders can borrow funds from their brokerage to buy stocks. Potential gains and losses are both increased by this leverage.
- Initial Margin: The investor is obliged by the broker to deposit a specific proportion of the purchase price at the outset when buying stocks on margin. The initial margin need is the term for this.
- Maintenance Margin: After the purchase, the investor must maintain a certain minimum amount of equity in the trading account.
- Margin Call Trigger: If the value of the securities falls below the maintenance margin, the broker issues a margin call, requiring the investor to deposit additional funds or securities to bring the account back to the required maintenance margin level.
- Purpose of Margin Call: This mechanism protects the broker from potential losses if the value of the securities continues to decline and ensures that the account has enough equity to cover the loan.
Practical Example:
Imagine an investor who wants to purchase $50,000 worth of Stock XYZ. The investor uses a margin account and is required to provide 50% of the purchase price as the initial margin, so they deposit $25,000. The broker lends the remaining $25,000.
- Initial Setup: The investor’s account has $50,000 in stock (bought on margin) and $25,000 in equity (the investor’s own money).
- Maintenance Margin Requirement: The broker requires a maintenance margin of 30%. Therefore, the investor must maintain at least $15,000 in equity (30% of $50,000).
Now, suppose the stock’s value drops to $40,000:
- Account Value After Decline: The account now holds $40,000 in stock, but the investor still owes $25,000 to the broker. This leaves the investor with $15,000 in equity.
- Margin Call: Since the equity ($15,000) is exactly at the maintenance margin threshold, any further drop in the stock value will trigger a margin call.
- Scenario: If the stock value drops to $38,000, the equity would be $13,000 ($38,000 – $25,000), which is below the maintenance margin requirement of $15,000.
In response to the margin call, the investor must either:
- Deposit Additional Funds: Add more money to the account to bring the equity back up to the maintenance margin.
- Sell Securities: Sell some of the securities to reduce the loan amount and restore the required equity level.
Risks and Considerations:
- Forced Liquidation: If the investor cannot meet the margin call, the broker can sell the securities in the account to bring the equity level up to the maintenance margin, often at an unfavorable price.
- High Risk: Trading on margin increases the potential for high returns but also for significant losses, especially in volatile markets.
Margin trading is a high-risk strategy and is generally advised for experienced investors who understand and can afford the potential losses.
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