Margin Call: Definition & Examples

Instructor: Ian Lord

Ian has an MBA and is a real estate investor, former health professions educator, and Air Force veteran.

A margin call can be an intimidating event for an investor. In this lesson we will look at what exactly a margin call is. Additionally, we will look go over the potential outcomes of the margin call.

Margin Call

Fred has recently opened a margin trading account with $40,000 of his own money and additional $40,000 borrowed from his broker. He's excited about the idea of being able to borrow money to buy more shares of stock and take advantage of leverage to magnify his returns. Unfortunately, the market hasn't been doing too well lately, and last week Fred received a courtesy email from his broker that he should be prepared for the possibility of a margin call. Let's take a look at what exactly a margin call is and put Fred's mind at ease with a hypothetical example of what would happen if one occurs.

Definition

A margin account is different than a regular investment account because it allows the investor to borrow money to buy securities such as stocks and bonds. A broker won't allow an investor to borrow all the money needed to buy an investment though; Fred is expected to have his own money or equity in the account. Federal law requires a minimum of 25% equity in a margin account. If Fred's equity as a percentage of the account drops below that amount, or a more restrictive limit set by the broker, the broker may issue a margin call. The margin call requires Fred to make a deposit to bring the equity back above the threshold or else some of the securities in the account will be sold in order to meet the minimum equity level.

An easy formula to determine the equity ratio is to subtract the amount borrowed from the current portfolio value, which gives us the equity, and divide that amount by the current portfolio value.

(Portfolio Value - Amount Borrowed) / Portfolio Value = Equity Ratio

Examples

Let's go back to Fred's portfolio. He put $40,000 of equity into the margin account and borrowed an additional $40,000 from his broker so he could buy $80,000 worth of stock. He bought $80,000 worth of XYZ stock at $80.00 per share for a total of 1000 shares. Unfortunately, XYZ just lost a major lawsuit and its share price has dropped to $50.00 per share. With the portfolio now worth $50,000, Fred only has $10,000 in equity after subtracting the $40,000 he borrowed.

Since $10,000 is only 16.67% of the $50,000 portfolio, Fred must put enough equity in to bring the equity ratio back above the Federally mandated 25%. Since 25% of $50,000 is $12,500, the margin call requires Fred to contribute at least $2,500 to meet the minimum standard. If he doesn't do this, than the broker will be forced to sell shares until the equity ratio rises above 25%.

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