The Basics of Margin Call in Trading

The world of finance uses probabilities of higher returns in exchange for risking more money. Margin trading shows how investors can use borrowed money to amplify their purchasing capability. However, this also means that potential losses can also be considerably high. It is where a margin call becomes essential. In this article, you will find out what is margin call, what is margin call in trading, and everything connected with it.

What is Margin Call?

A margin call is a crucial notice a broker gives an investor with a margin account. A margin account enables an investor to buy securities with money borrowed from the broker and usually applies to stocks or bonds. The borrowed funds, referred to as margin, are used to increase the investor’s initial capital so he can purchase more assets. However, this leverage comes with a condition: the investor has to preserve a specific minimum of equity in the account as a percentage of the total value of the position. This minimum equity level is referred to as the maintenance margin.

Understanding Margin Call in Trading Requirements

Brokers set margin requirements, including the initial margin that an investor has to stake into the account before trading begins and the maintenance margin that must be maintained in the account at any time throughout the trading period. These are usually quantified as a fraction of the total value of the position.

For instance, an initial margin of 50% means that an investor must put up their own money equal to 50% of the stocks they want to buy on the margin. Similarly, a 30% maintenance margin means that the total of the investor’s equity in the account (actual money plus any profits that the holder is yet to reap from the stocks) must not be less than 30% of the total value of the position at any one time.

Situations Leading to a Margin Call

Let’s look at what can cause a margin call if an investor buys stocks worth Rs. 100,000 with a 50% initial margin. It means they use Rs.50,000 of their own money and borrow Rs. 50,000 from the broker. The initial equity is Rs.50,000. If the stock price drops by 20%, the stock value falls to Rs. 80,000. As a result, the investor’s equity decreases to Rs. 30,000 (80% of Rs. 50,000 invested + Rs. 20,000 unrealized loss).

It is where the maintenance margin is essential. If the equity level falls below the 30% threshold (Rs.30,000 in this case, or 30% of Rs.100,000), the broker triggers a margin call. This margin call requires the investor to add more money to their account to meet the maintenance margin requirement.

Responding to a Margin Call

There are three primary ways an investor can respond to a margin call:

1. Deposit Additional Funds: The most straightforward approach is to deposit additional cash into the account. It increases the investor’s equity and brings it back above the maintenance margin.
2. Sell Assets: The investor can sell a portion of their holdings to generate cash. The proceeds from the sale are then used to reduce the loan amount and restore the maintenance margin.
3. Liquidation by Broker: If the investor fails to respond to the margin call within a stipulated time frame, the broker can forcibly liquidate a sufficient amount of the investor’s holdings to meet the maintenance margin requirement. It can be a highly undesirable outcome, as the investor may be forced to sell assets at a loss, potentially amplifying the financial repercussions.

The Risks and Rewards of Margin Trading

Margin trading has the potential to significantly increase both profits and losses, making it a strategy with considerable risk and reward. Here is a look at the potential outcomes:

Rewards

Enhanced Purchasing Power

By obtaining a loan from a broker, you can purchase more stocks than you could with your own money alone. This leverage can result in greater profits if stock prices increase.

Potential for Higher Returns

Since you’re using borrowed funds, the return on your invested capital can be significantly higher if your investments perform well.

Risks

Magnified Losses

Just as gains can be amplified, so can losses. If the stock price falls, you lose money on your investment and have to repay the borrowed funds, leading to higher losses.

Margin Calls

The broker will issue a margin call if your equity falls below the required maintenance margin. You will need to add more money to your account or sell some of your assets to meet the margin requirements, which could force you to realise losses.

Interest Costs

Borrowing money comes with interest, which can accumulate and decrease your total returns, especially if you hold the position for a long time.

Market Volatility

Sudden market swings can quickly erode your equity, triggering margin calls and forcing you to take action at potentially unfavourable times.

Mitigating Margin Call Risks

Minimising the risk of encountering a Margin Call

Investors employing margin accounts should adhere to several best practices:

Maintain a Conservative Leverage Ratio

Utilise a lower leverage ratio by investing more of your capital. It creates a buffer zone and reduces the likelihood of the equity falling below the maintenance margin.

Establish Stop-Loss Orders

Implement stop-loss orders to automatically sell holdings if the price falls below a predetermined level. This helps limit potential losses and prevents the equity from dropping significantly.

Monitor Market Volatility

Closely monitor market fluctuations and adjust your portfolio accordingly. During heightened volatility, reducing your leverage ratio or exiting certain positions to safeguard your capital is prudent. Remember, margin calls are more likely to occur during market downturns when asset prices experience a decline.

Diversify Your Portfolio

Don’t concentrate your investments in a single security or sector. A diversified portfolio distributes the risk and lessens the effect of a price drop in any single asset on your total equity.

Understand Your Risk Tolerance

Be honest about your risk tolerance. Margin trading is inherently risky and not suitable for all investors. Only engage in margin trading if you are comfortable with the potential for substantial losses.

The Advantages and Disadvantages of Margin Trading

Despite the inherent risks, margin trading can be a valuable tool for experienced investors seeking to amplify their returns. Let’s explore some of the potential advantages and disadvantages of employing a margin account:

Advantages

• Magnified Profits: Margin trading can significantly increase potential returns when the market moves in the investor’s favor. Leveraging borrowed funds allows investors to control a more prominent position size, potentially leading to amplified gains.
• Short Selling Opportunities: Margin accounts facilitate short selling, a strategy allowing investors to profit from declining asset prices. By borrowing shares from the broker, the investor can sell them immediately, hoping to repurchase them later at a lower price and return them to the broker, pocketing the difference.

Disadvantages

• Amplified Losses: As previously discussed, margin trading magnifies profits and losses. A decline in asset prices can quickly erode the equity in the account, triggering a margin call.
• Increased Risk of Forced Liquidation: The pressure to meet a margin call in trading can force investors to sell holdings at inopportune moments, potentially crystallising losses. It can be particularly detrimental if the investor has a long-term investment horizon.
  Interest Expense: Investors utilising margin accounts incur interest on the borrowed funds. This continuous expense reduces potential returns and should be considered in the overall investment strategy.

Who Should Consider Margin Trading?

Margin trading is generally not recommended for novice investors. It requires a sophisticated understanding of market dynamics, effective risk management strategies, and maintaining composure under pressure. A risky trade can lead to big wins or significant losses. So, who should even think about using margin?

The Risk-taking Investor

If you’re comfortable taking on extra risk and have a high tolerance for potential losses, then margin trading might be an option. You will need to be prepared for the market to move against you quickly, potentially triggering a margin call in trading.

The Experienced Trader

Margin trading demands a thorough understanding of the markets and their movements. If you’re a seasoned trader with a proven track record, you might be better equipped to handle the complexities of margin.

Those with a Large Portfolio

Investors with significant capital can potentially absorb more considerable losses if things go south. They can also use their existing holdings as collateral to borrow less, reducing the risk of a margin call.

Those with a Short-Term Focus

Margin trading is often used for short-term bets on stock prices. If you’re looking to capitalise on a quick swing in the market, margin can help amplify your gains (or losses).

Margin trading is most appropriate for investors who are comfortable with high risk, have a good understanding of the markets, and have a solid financial foundation to absorb potential losses.

Margin call in trading can be both profitable and risky. It can increase your gains but also increase your losses. It is essential to understand the risks and margin calls before you start. Using low leverage, setting stop-loss orders, watching market changes, and diversifying your investments can help you manage margin trading better.

Margin call in trading can be profitable, but it’s not for everyone. If you are unsure regarding any investment, want to know, what is margin call? talk to a financial advisor. If you’re an experienced investor comfortable with high risk and knowledgeable about the markets, margin trading might be worth considering. SMC Global Securities offers financial services, including margin accounts and expert advice. Contact SMC Global Securities to learn how margin trading could benefit your investments.