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If you invest in stocks using borrowed money, understanding margin calls is important. A margin call happens when your account balance falls below the required limit set by your broker. When this happens, your broker asks you to add more funds to maintain your investments.
While it might sound complicated, knowing how margin calls work can help you manage your investments wisely. In this article, we’ll break down what a margin call is, why it happens and how to handle it effectively so you can invest with confidence.
What is a Margin Call?
Margin call happens when your broker asks you to add more money to your account or sell some of your investments. This happens when the value of your holdings falls below the required minimum needed to support the money you borrowed for trading. It’s a warning that your account doesn’t have enough equity and you need to act fast to avoid losses or forced liquidation. If you trade on margin, understanding margin calls is important to managing risk and protecting your investments.
How Does Margin Call Work?
Margin trading allows investors to borrow money from a broker to buy more stocks or securities than they could with their own funds. To get started, investors must deposit a minimum amount, known as the initial margin which serves as collateral for the loan. This amount is set by the broker or regulatory authorities and is usually a percentage of the total trade value.
Once the trade is active, investors must maintain a minimum balance, called maintenance margin, to keep their positions open. If losses reduce the account’s equity below this threshold, the broker issues a margin call asking for more funds or securities to restore the balance. If the investor doesn’t act broker may sell some or all of the holdings to recover the borrowed money.
While margin trading can increase profits, it also increases risks as losses can surpass the initial investment. Understanding margin requirements and risk management is important for investors considering this strategy.
Example:
Step 1: Opening a Margin Account
When an investor wants to trade on margin, they open margin account with a broker which allows investors to borrow money to buy stocks.
- Brokers require an initial margin of 50%, meaning the investor must invest half of the stock’s value with their own money.
- If you want to buy shares worth ₹1,00,000 you need to deposit ₹50,000 of your own money and the broker lends you the remaining ₹50,000.
Step 2: What Happens When Stock Prices Drop?
Stock prices don’t always go up. If the value of your stocks falls, your equity decreases.
- Suppose the value of your shares drops to ₹60,000
- You still owe the broker ₹50,000.
- Your equity = ₹60,000 (stock value) - ₹50,000 (loan) = ₹10,000
Step 3: Maintenance Margin Requirement
Brokers set a minimum equity requirement, called maintenance margin. Usually, this is 25% of the stock’s current value.
- In this case, 25% of ₹60,000 = ₹15,000.
- But your equity is only ₹10,000, which is below the required ₹15,000
Step 4: Margin Call – Warning from the Broker
Since your equity has fallen below the minimum requirement broker issues a margin call. It means you must deposit ₹5,000 more to bring your equity up to ₹15,000.
Step 5: What If You Don’t Add Funds?
If you fail to meet the margin call broker has the right to sell your stocks to recover the loan amount. Your broker may sell some or all of your shares until they recover the borrowed ₹50,000.
What Happens if You Get a Margin Call?
Margin call happens when your broker notifies you that your account balance has dropped below the required margin level. Here’s what happens next:
- Notification:
Your broker will inform you via email, phone or platform alert that your account no longer meets the minimum margin requirement. This usually happens due to market losses or when your account falls below the maintenance margin.
- Deposit More Funds
To keep your positions open, you’ll need to deposit additional cash to meet the margin requirement.
- Forced Liquidation:
If you don’t meet the margin call in time, your broker can sell some or all of your securities without your permission to bring your account back into compliance.
- Potential Losses:
If your broker sells your securities at a loss, you could end up with less money than you started with. In extreme cases, you might still owe money even after the liquidation.
Formula for Margin Call
To avoid surprises, you can calculate the price at which a margin call might occur using this simple formula:
- Margin Call Price = Initial Purchase Price × [(1 – Initial Margin) ÷ (1 – Maintenance Margin)]
Let’s say you purchase securities worth ₹1,20,000 using a margin loan, with an initial margin of 60% and a maintenance margin requirement of 35%.
- Margin Call Price = ₹1,20,000 × [(1 – 0.60) ÷ (1 – 0.35)]
- Margin Call Price = ₹73,846
If the total value of your securities drops below ₹73,846, your broker will issue a margin call, requiring you to either add more funds or sell some securities to restore your account balance.
How to Respond to a Margin Call
Margin call can be stressful but knowing how to respond can help you protect your investments and avoid unnecessary losses. When you receive a margin call, you generally have two options:
- Option 1: Deposit Additional Funds
One way to meet a margin call is to add funds to your margin account. This increases your equity and helps you maintain required margin level. By depositing cash you avoid selling securities which can be beneficial if the market is facing a downturn.
For example, if you receive a margin call of ₹10,000, you can deposit that amount into your account to restore your equity and keep your investments intact. This option is ideal for investors who believe in the lonterm potential of their holdings and want to avoid selling assets at a loss.
- Option 2: Sell Some Securities
If adding funds isn’t an option, you can sell some of your securities to free up cash. Selling assets can bring your account back to the required equity level but it comes with risks especially if the market is down. Selling at a loss could negatively impact your longterm investment strategy.
For example, if your portfolio is worth ₹50,000 and you need to cover a ₹10,000 margin call, selling a portion of your holdings can help you meet the requirement. However, before liquidating assets consider whether this aligns with your financial goals and market outlook.
Ways to Avoid Margin Calls
Maintaining a strong trading strategy is important to avoid margin calls. To avoid margin call here are some ways that can help you.
- Monitor Your Margin Balance Regularly
Keeping a close eye on your margin balance helps you stay in control of your trades. By tracking your available margin, you can anticipate potential shortfalls and act before a margin call is triggered. This may help you to adjust your strategy based on market conditions.
- Set Price Alerts for Market Drops
Most trading platforms offer price alerts that notify you when your assets drop in value. Setting up alerts gives you time to add funds or adjust your positions before reaching the margin call.
- Use Leverage Wisely
Leverage can increase your profits but also increase risks. Avoid borrowing excessively as even small market fluctuations can result in margin call. A safer approach is to use leverage conservatively and keep sufficiently cash reserves to handle market volatility.
- Diversify Your Portfolio
Having a well diversified portfolio reduces risk. Instead of relying on a single stock or asset, spread your investments across different sectors or instruments. It helps minimize losses if one asset performs poorly.
- Maintain a Safety Cushion
Always keep extra funds in your account as a buffer. This additional margin can help absorb market fluctuations and prevent forced liquidations.
- Stay Updated on Market Trends
Being aware of economic news, interest rate changes and market trends helps you make informed trading decisions. Sudden market shifts can lead to margin calls, so staying informed allows you to act proactively.
Consequences of Ignoring Margin Call
Ignoring a margin call can have serious financial consequences potentially putting your investments and capital at risk. Here’s what can happen if you fail to act
- Monitor Your Margin Balance Regularly: If you don’t meet the margin call within the given timeframe, your broker has the right to sell part or all of your holdings to cover the shortfall. It means you could lose valuable assets, sometimes at unfavorable market prices, leading to unexpected losses.
- Additional Fees and Penalties: On top of the forced liquidation, you might incur extra fees such as administrative charges and interest on borrowed funds. These costs can add up and reduce your overall investment returns.
- Negative Account Balance: If the proceeds from the sale of your holdings don’t fully cover the margin deficit, your account may go into a negative balance. Means you owe money to your broker, which could impact your credit score and limit your ability to trade in the future.
- Trading Restrictions Until you clear margin shortfall and bring your account back to the required level, your broker may restrict or even suspend you to trade. This could prevent you from making new investments or taking advantage of market opportunities.
Final Words
Managing margin calls effectively is important to protecting your investments. Keep a close eye on your margin balance, use leverage wisely and take quick action if a margin call happens. This helps you reduce risks, prevent forced liquidation and maintain a good relationship with your broker. And always have a risk management strategy in place such as setting stoploss orders and keeping extra funds in your account to handle market fluctuations.
Frequently Asked Questions
What is a margin call?
Margin call happens when your account value drops and the broker asks you to add funds or sell assets to cover losses.
How is a margin call calculated?
It’s based on your securitie’s value and the broker’s maintenance margin. If your equity falls below this level you get a margin call.
How to avoid a margin call?
Monitor your margin balance, set alerts for drops and use leverage wisely to maintain sufficient equity.
What happens if you ignore a margin call?
If you don’t meet the margin call, the broker may sell your assets to recover the shortfall.
Can a margin call be reversed?
Yes, by adding funds or increasing your portfolio’s value before the broker liquidates your assets.
Happy investing and thank you for reading!
Disclaimer:
This website content is only for educational purposes, not investment advice. Before making any investment, it’s important to do your own research and be fully informed. Investing in the stock market includes risks, and you should carefully read the Risk Disclosure documents before proceeding. Please remember that past performance doesn’t guarantee future results, and due to market fluctuations, your investment goals may not always be achieved.
