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.
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.
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
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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But what if Fred didn't put all his money in one stock? Suppose he bought $40,000 of XYZ and $40,000 of BCD. Each stock was bought at $80 a share. XYZ now sells for $50 per share and BCD sells for $81. The portfolio is worth $65,500, and after subtracting the borrowed $40,000 Fred has equity of $25,500. This gives him an equity ratio of 38.93%. Even though XYZ has taken a significant loss, since Fred's portfolio total is above the minimum he will not receive a margin call.
A margin call is when a broker requires an investor who trades in a margin account to contribute additional equity in order to maintain a minimum ratio. A margin account allows investors to borrow money from the broker to invest, but an investor must have a minimum amount of his own money or equity in the account in addition to the borrowed funds. Federal law requires at least 25% equity in a margin account, though some brokers may have more restrictive standards. If the total portfolio equity ratio drops below this threshold, the broker will sell shares of portfolio investments until the ratio rises to an acceptable level. Investors can prevent this by sending additional money to the account in order to increase the equity ratio.
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