Understanding Margin Calls
In volatile markets stock prices can fall rapidly. If your account falls below your brokerage firm's maintenance requirement (maintenance margin) the firm will generally issue a "margin call". The margin call will ask you to add more cash or securities to your account. If however you are unable to meet this request, the firm will sell your securities in order to increase the equity in your account up to the required maintenance margin.
How does a Maintenance Margin Call Work?
To illustrate better how a margin call works, consider the following example:
You have bought $50,000 worth of securities by paying in cash $25,000 and borrowing $25,000 from your broker. Let's say the market value of your securities drops to $30,000; thus, the equity in your account will be $30,000 - $25,000 = $5,000. If we assume that the firm's maintenance requirement is 25%, then you should have a minimum of $7,500 in your account (25% of $30,000), which you don't because you have only $5,000 worth of equity in your account. As a result, your firm may make a margin call.
Have in mind that your broker may not be obliged to make a margin call and may be able to sell your securities without preliminary notification and without consulting you first. Additionally, most margin agreements allow brokerage firms to sell your securities without giving you time to meet the margin call and increase the equity in your account.
Margin accounts may contribute to rapid financial losses without notice. Thus, before you open a margin account, make sure you understand margin calls well and always read carefully the margin agreement. Here are some facts you should be aware of:
- Buying on margin may make you lose more money than what you have initially invested.
- Margin accounts hide greater risks than cash accounts where you pay in full the securities you buy.
- You will be charged for borrowing money from your firm, which will inevitably affect your overall return. Know exactly how much you will be charged.
- If you don't have the required equity in your margin account the brokerage firm may sell your securities to increase your account equity without waiting for you to meet the margin call.
- You cannot control which stock will be sold to cover the margin call.
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