Brokers are free to set their own rules, but under regulations set by the Financial Industry Regulatory Authority (FINRA) and the Federal Reserve Board, a broker may lend up to 50% of a security’s price on margin. After the purchase, they’ll keep track of the value of your securities compared to debt. The minimum amount of equity you must maintain in your account is called the maintenance margin. While 25% is the lowest requirement allowed by law, many brokers set it at 30% or 40%. However, some securities could even require 75% to 100%. Brokers have automated systems to monitor customer equity and programs that will issue an alarm, notification, or action if that equity drops below the requirements. When you face a margin call, you can respond by selling securities to meet the maintenance margin requirement or by adding cash to your account. If you don’t do either, your brokerage can sell your investments without your permission to pay off your debt. The broker can even do so without contacting you. Margin requirements protect both the investor and brokerage companies, and shield the market from volatility and bubbles caused by massive speculation in securities. Rampant borrowing for speculation was a contributing factor to the 1929 stock market collapse. Margin calls mean brokers won’t lose massive amounts from unpaid loans. They also, to a point, protect investors from catastrophic losses by forcing them to sell out of positions they can’t afford to hold. Imagine a situation where someone could borrow hundreds of thousands or millions of dollars to invest in a company. If that company’s share price dropped by just a few dollars, that investor could easily lose more money than they have. This could leave investors bankrupt and brokers losing large amounts of money.
Example of Margin Call
To determine whether you’re meeting the maintenance margin requirement, multiply your account balance by the maintenance margin. If your equity (what you own) is lower than that amount, your broker will initiate a margin call. Let’s say John wants to invest in XYZ Company, which is trading at $100 per share. John has $50,000 to invest and wants to buy as many shares as possible. Using margin, he can buy 1,000 shares with his own money and $50,000 on margin from his broker. In total, John now owns $100,000 worth of shares. XYZ Company’s stock then drops in price to $60 per share. John will have just $10,000 in equity compared to the $60,000 in securities in his account. This will trigger a margin call because: $60,000 x 0.25 = $15,000 (the amount of equity John is required to have) $10,000 is less than $15,000 John must make a decision, which could include depositing or transferring cash or more marginable XYZ stock, or closing out positions to bring his account to the required level of $15,000. If John does nothing, his brokerage may liquidate his shares of XYZ Company without contacting him.
Avoiding a Margin Call
If you’re concerned a margin call might occur soon due to market volatility or a rapidly dropping stock price, you have a few options—but you also need to consider tax implications that could result. To avoid margin calls in the future, plan how you’ll react to a drop in the stock’s price and how you’ll handle a potential margin call. This may mean borrowing less than allowed, keeping a personal margin higher than the brokerage’s margin, and diversifying and monitoring your portfolio more closely. Investors can also use cash accounts to pay for the securities bought. Cash investment accounts may come with additional restrictions, however. For example, you can’t buy and sell a security before paying for it.
