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Key takeaways
- A margin call happens when a broker demands an investor bring their margin account to the required minimum threshold level by depositing additional funds or selling securities.
- If you cannot meet a margin call, your stock broker can sell your securities without your approval. They will likely do this without considering your losses or tax preferences.
- It’s important to understand the risks involved with margin trading because when something seems too good to be true, it almost always is.
As you become more entrenched in investing, you’ll inevitably hear terms like options, margin calls and margin trading. These terms may seem intimidating if you’re new to investing, so we’ll do our best to simplify them here along with a practical explanation for investors.
Many investors will open a margin account so they can invest on margin, meaning they borrow money from a broker to purchase specific securities. Buying on margin can magnify potential profits, but it can also magnify potential losses.
This is a risk of margin trading and might result in a margin call, especially in times of extreme market volatility. We’re going to look at the definition of a margin call and what you can do to avoid getting one when you trade options.
What’s margin trading?
Before we discuss margin calls, let’s look at margin trading in general. When you buy on margin or start margin trading, you borrow money from your stock broker to purchase securities. When you open a margin account with any investment brokerage, you can purchase securities (stocks, bonds, ETFs) with a mix of your money and the money that the broker lends you.
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The money you borrow to invest is referred to as margin. This margin will allow you to invest more money into securities. This means that you could amplify your potential profits if the share price goes up and you manage to sell high. But you also run the risk of the security dropping in value and having no way of paying back the money you borrowed.
Note that if your margin account drops too much and you’re unable to meet the margin call, your stock broker can sell your securities without your permission and with no regard for tax strategies. While you typically have two to five days to handle the situation, you certainly don’t want to test the broker by missing the deadline.
What’s a margin call?
A margin call happens when the value of the investments in a brokerage account drop below a specific level, referred to as the maintenance margin. The account holder is then required to deposit additional money or securities to reach the required margin level.
Essentially a margin call means that your broker wants you to contribute more funds or sell your current securities to meet the maintenance requirement. This usually comes after a drop in the value of the securities held in your account. If you don’t take action, then the broker can sell your assets in order to bring your account into good standing again.
You also won’t be able to purchase more securities through your brokerage account until you fulfill the margin call requirements.
Why do margin calls happen?
A margin call will typically happen when there’s a period of extreme stock market volatility. Here are a few situations that could lead to a margin call.
- Market volatility. When there’s a lot of market volatility, the prices of securities will fluctuate and could decline in value by a substantial amount.
- Your account is running low on money, likely due to a poor trade. In a perfect world, we would always buy low and sell high. As we saw in 2022, you can think that you’re buying low and proceed to watch the security drop another 50% by the end of the year.
The frightening thing about margin calls is that they usually occur during times of market volatility. This may mean selling your securities at an even lower price than usual to fund the account.
When we looked at Carvana stock, we noted how shares had dropped by 98% for the year at one point. Folks who purchased shares of this company on margin during the year, thinking it would rebound, were likely hit with a margin call due to the high volatility. While this is just one example, you can look at almost any security from 2022 and see it was a tough year to invest in the stock market, let alone borrow money for investing.
How do you avoid a margin call when trading options?
Generally speaking, you need to have a margin account when you trade options. You’re going to want to either avoid dealing with margin calls altogether or do your best to prepare for one.
How can you avoid a margin call?
- Have the extra funds available. It’s important that you have money available to deposit into your margin account in case something happens.
- Diversify your investments. You can limit the volatility of your margin account by diversifying the securities you’re trading.
- Monitor your account. Track your investments and your account to be prepared for whatever may happen.
Is margin trading risky?
Anytime that you borrow money to invest, you’re taking on significant risk. During economic growth, it’s easy to boast about how much investments have appreciated.
However, when as the economy takes a downturn, we see even the biggest companies drop in value due to widespread stock market sell-offs. Soaring inflation impacted the economy in a big way last year, the Fed decided to battle it with an aggressive rate hike campaign. The result was massive stock market sell-offs throughout the year. This made sophisticated investment strategies like margin trading especially risky, and many folks have lost significant amounts of their capital.
In 2021, Robinhood was fined nearly $70 million by the Financial Industry Regulatory Authority (FINRA) due to allegations that the brokerage caused “widespread and significant” harm to its customers. FINRA alleged that Robinhood had spread false and misleading information on complex financial topics like placing trades on margin.
Many investors who should not have taken on the risks of options trading were approved for it by Robinhood. FINRA found that false information from Robinhood cost customers upwards of $7 million.
What else do you need to know?
Investing in the stock market on margin comes with many risks, and it wouldn’t be recommended if you’re trying to save for an important goal or if you have a relatively low risk tolerance. For example, you may not want to invest the money that you intend on using for your wedding or buying your first house next year through this strategy.
What happens when you sell the stocks you purchase on margin?
Similar to when you sell your house, you first have to use the proceeds from your sale to pay off the brokerage for the money you borrowed. Then you get your funds, assuming you were able to earn a profit.
What’s a maintenance margin?
This is the minimum amount of money an investor must hold in their margin account after a purchase. If your account falls below this level, a margin call will be triggered, and you’ll have to deposit additional funds or sell off investments.
FINRA mandates that investors maintain a minimum equity level that amounts to 25% of the total value of their securities held when engaging in margin trading. Some brokers will have a higher maintenance requirement, up to 30% or even 40%.
How much margin is considered a safe amount?
There isn’t a set amount of money considered safe to borrow and invest because we all have different financial situations. Be sure to factor in the possibility that you could lose money with your margin trading and be stuck paying off the initial loan from the broker.
Let’s say you borrow money to invest $5,000 in a stock you feel is a strong bet – if the account drops and you receive a margin call, you have to find a way to fund this account or sell this investment at a loss. Then you have to worry about paying back your margin loan along with any interest or fees your broker chooses to charge.
How should you be investing?
While there are many success stories of folks who make a good return from margin trading, it’s not for the faint of heart or the uninitiated.
If you’re uncertain about how you should be investing your money, Q.ai can help. Our artificial intelligence scours the markets for the best investments for all manner of risk tolerances and economic situations. Then, it bundles them in handy Investment Kits that make investing both straightforward and strategic.
Best of all, you can activate Portfolio Protection at any time to protect your gains and reduce your losses, no matter what industry you invest in.
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