A margin call is a wake-up call from your broker. When an investor's equity in a margin account drops below the minimum amount required by the broker, a margin call happens. Securities purchased using a combination of the investor's own funds and funds borrowed from the investor's broker are kept in an investor's margin account.
When a broker requests that an investor add more funds or securities to the account, it is known as a "margin call." This occurs when the investor's equity and the account value reach the minimum amount specified by the maintenance requirement.
Example: The Margin Call in Action
Let's say you buy ₹10,000 worth of stock using margin, meaning you borrow ₹5,000 from your broker. The maintenance margin might be 30%, which means the total value of your account (including the borrowed money) needs to stay above ₹7,000 (₹10,000 x 30%).
If the stock price falls, and the value of your account drops below ₹7,000, you'll get a margin call. You'll then need to deposit more money (or sell some stock) to bring the account value back up to the maintenance margin level.
Types of Margin
Margin trading involves borrowing funds from a broker to purchase securities. Here are the three main types of margin used in trading:
1. Initial Margin:
The amount of margin required to open a new position.
Example: If you want to buy ₹50,000 worth of stock, and the initial margin requirement is 50%, you'll need to deposit ₹25,000 in your account.
2. Maintenance Margin:
The minimum amount of equity you must maintain in your account to keep positions open.
Example: If the maintenance margin requirement is 25% and your account equity drops below this level due to losses, you'll receive a margin call.
3. Margin Call:
A demand from the broker for additional funds or securities if your account falls below the maintenance margin.
Example: If your account equity drops below the maintenance margin requirement, your broker will issue a margin call asking you to deposit more funds or securities to meet the margin requirement.
When Does a Margin Call Happen?
A margin call occurs when the value of your securities falls below the maintenance margin set by your broker. This usually happens if the market value of your borrowed securities drops. If this occurs, your broker will ask for more funds or securities to bring the margin back up.
How to Avoid Margin Calls:
Here are some smart moves to avoid getting a margin call:
- Keep cash handy: Just like having some savings for your car, having extra cash in your brokerage account acts as a buffer.
- Watch Your Portfolio: Regularly monitor your account value and the maintenance margin requirement. This way, you can see if you're getting close to a margin call and take action.
- Diversify Your Investments: Don't put all your eggs in one basket! Invest in a variety of stocks, bonds, and other assets to spread out your risk.
- Set Stop-Loss Orders: A stop-loss order automatically sells a stock if the price falls below a certain level. This can help limit potential losses and reduce the chance of a margin call.
The Bottom Line
Margin calls can be stressful, but by understanding them and using good risk management practices, you can avoid them and trade more confidently.
Most investors saving for long-term goals, like retirement, should avoid buying stocks on margin due to the higher risk.
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