What Is a Margin Call and What Happens If I Get One?

What Is a Margin Call and What Happens If I Get One explained by professional Forex trading experts the “ForexSQ” FX trading team. 

What Is a Margin Call and What Happens If I Get One?

One of the most unpleasant experiences an investor, trader, or speculator might face in his or her lifetime is known as a margin call. What is a margin call? Why can they be so unpleasant or induce panic in otherwise calm people? Those are great questions and it’s definitely important you know the answer before you find yourself facing such an event. A little prevention and conservatism, in the beginning, can save you a lot of pain down the line.

Before You Can Understand a Margin Call, You Need to Understand How Margin Debt Works

When you open a margin account with your stock broker, future broker, or commodities broker, you effectively tell them that, at some point, you may want to borrow money from them. You do this by hypothecating the cash and securities in your account (pledging them as collateral for the loan, which they can then rehypothecate; a potential disaster waiting to happen under the wrong circumstances that could result in your money being seized by their creditors and making you ineligible for SIPC protection were the institution you are trusting ever to do anything stupid) as well as providing an unconditional, unlimited personal guarantee obligating the repayment. Even if your account gets wiped out, you are legally bound to come up with the entire remaining debt balance. That is, you can lose much more than the funds you have deposited into your account.

While it can be tempting to invest or speculate on margin when interest rates are low, there are significant dangers to this behavior, even if you are engaging in what you believe is a relatively conservative cash carry operation. This is because anytime you trade on margin, you’ve introduced the possibility of a margin call.

Specifically, a margin call occurs when the required equity relative to the debt in your account has fallen below certain limits and the broker demands immediate rectification, either by depositing additional funds, liquidating holdings, or a combination.

A margin call may happen for any number of reasons.

Firstly, you might fall below the regulatory requirements governing margin debt due to fluctuations in asset prices or changes by regulators. Federal Reserve Regulation T makes it possible for the nation’s central bank to enforce minimum margin debt-to-equity requirements as a way to avoid the excessive over-leveraging and speculation that occurred in the 1920’s. For example, the current rules state that when dealing with stocks on the New York Stock Exchange, the borrower must have at least 50% equity at the time of purchase and must maintain, at all times, at least 25% equity. That is, if you had $100,000 in a margin account, you could borrow $100,000, taking your total assets to $200,000 of which half was debt and half was equity and might not face a margin call until the account declined by 33.33% to $133,333, at which point the debt ($100,000) would be 75% of the total account balance ($133,333) with the equity ($33,333) making up the remainder.

If the bankers wanted to do so, they could ban short selling outright and require instant repayment of all margin debt. There are also additional restrictions on margin debt, such as a limit for accounts of less than a certain size ($2,000) or when trading so-called penny stocks. These days, updates to the regulations have made the rules a bit more complicated – for example, certain traders might take advantage of something known as “portfolio margin”, which can drastically reduce the margin requirements (and therefore probability of a margin call) that would apply to a portfolio if there are offsetting hedges or other relevant factors that reduce risk – but those are not necessary to discuss at the moment.

Secondly, your brokerage firm might change its margin policy for your account if it no longer considers you a good risk, a specific security to which you have exposure if it thinks the risk exposure warrants it, or any number of reasons, none of which have to be fair or serve your best interests.

For example, many brokerage firms set margin maintenance requirements much higher than the minimum regulatory rules. This is because the brokers don’t want to be on the hook for borrowed money that you can’t repay so the bigger the equity cushion to absorb losses, the safer it is for them and their owners, shareholders, and lenders. In practical terms, this effectively means that the margin debt exists at the pleasure of the brokerage house and they can demand repayment at any time, without giving you notice.

When a situation arises in which your account no longer has the necessary equity-to-debt ratio required by either the broker’s own internal house rules for margin maintenance or those set as minimum guidelines by the Federal Reserve, a margin call is issued.

What Happens When You Get a Margin Call

A margin call is most often issued these days by placing a large banner or notification on the website when an investor or speculator logs in to check his or her account balance. Some brokers offer notifications through email, phone calls, or text messages.

If the broker is amenable and not worried about your financial condition, it may give you time to deposit fresh cash or securities in your account, raising the equity value to a level considered acceptable either by the internal margin debt guidelines or the applicable regulations.  If it isn’t – and assume this will always be the case – representatives may begin winding down your holdings to raise as much cash as possible. That is an important point. The broker is almost always interested solely in protecting its own financial condition and doesn’t want to find itself having to go after you to collect a debt. As a result, and as spelled out in your account agreement, it is under no obligation to give you additional time to meet a margin call or to consult you prior to liquidating assets in your account to cover any margin debt. This means the broker can decide to sell highly appreciated securities with big deferred tax liabilities, triggering major capital gains expenses for you, even if you don’t want them to do so. This means the broker can sell severely undervalued stocks or bonds at the worst possible moment, leaving you no choice in the matter, permanently locking in your losses. They don’t even have to call you on the phone or give you a chance to react first, so you may not get a chance to rectify the situation even if the funds are available to you.

You knew this going into the relationship, you signed the account agreement that spelled it out clearly, you have to live with the consequences. Don’t complain. If you didn’t like it, you shouldn’t have promised to abide by those rules.

What Happens If You Can’t Meet a Margin Call?

The seriousness of a margin call, especially if it leads to debts that you cannot afford to pay, should not be understated. If you are unable to meet a margin call, and assets have already been liquidated in your account to repay the debt, you will find that the remaining balance owed becomes an unsecured debt that is now in default. Among other things, it is entirely possible for the following to happen:

  • The debt will be reported to the credit agencies making borrowing money difficult if not impossible as your credit score is slammed. Additionally, its presence may cause your other lenders to cut off access to their products (e.g., a credit card company closing your account) or raise the interest rate you are charged as an offset to the higher risk you now represent. If you have business loans or other liabilities that permit accelerated maturity in the event of a major change in your financial condition, you may find the entire balance owed on those debts, as well.
  • Universal default may be triggered and, in jurisdictions where it is permitted, you may find your insurance rates on your home, cars, or other policies increasing substantially as you are now considered deficient in character at the same time your ability to find a job is hindered as some states allow companies to factor in credit histories as being indicative of responsibility and capability.
  • The broker will launch a lawsuit against you demanding immediate repayment, including legal costs. The remedies available will depend upon the specific laws of the state but may include forcing you to disclose your entire financial situation (income, assets, debts) under oath, having bank accounts and other personal property garnished or seized, including putting real estate investments up for sale.

In many cases, the best option may be to raise money however you can and wipe out the debt within days, even if it means selling other assets such as cars or furniture. Alternatively, it may be advisable to consult as quickly as possible with a bankruptcy attorney (if filing is the right call, the sooner you can do it, the better). For example, in some situations, it may be a superior alternative to accept the pain of bankruptcy and protect the money within your 401(k), 403(b), Roth IRA, or other retirement plan, as they are often beyond the reach of creditors. The worst possible thing you can do to meet a margin call is to drain these accounts, get slammed with ordinary taxes plus an additional 10% penalty tax, then declare bankruptcy, anyway, because it wasn’t sufficient to pay the entire balance. If you can start rebuilding with a huge head start, why not do it?

A Real-World Example of a Margin Call

On my personal blog, I recently wrote about a 32-year-old small business owner in Arizona who faced a life-altering margin call. At the start of the debacle, he had around $37,000 in a brokerage account.  He decided to short stock, which requires a margin account. (In simplified terms, instead of borrowing cash, he borrowed shares of stock from other investors through the brokerage firm, promising to return the shares at some point in the future. He then sold that stock, pocketing the cash. The hope was the stock would decline in market price, he could repurchase shares later, at a lower price, and return those newly bought shares to the original lender. His profit would have been the difference between the price at which he originally sold the borrowed stock and the price at which he repurchased the cheaper stock, adjusted for fees, costs, and other expenses. Additionally, he would have had to make any dividend payments during this time so the person from whom he borrowed the shares was still receiving the income, which would reduce his overall profitability were any to be declared as they would have represented an outflow to him.)

Overnight, the stock skyrocketed. The next day, he found that his account had generated losses of $144,405 (the cost it would take to repurchase the shares he had borrowed and sold). With all of his equity obliterated, he was faced with a $106,445.56 margin call to his brokerage firm, E-Trade.  Take a look at the screenshots; it’s sickening.

You saw these same sorts of margin calls on the long-side when Apple supplier G.T. Advanced Technologies went bankrupt. Some men and women had placed all of their equity in accounts, borrowed on margin to acquire more shares than they could otherwise afford, and found themselves in total ruin when a cash crunch at the corporation resulted in a shocking bankruptcy. One woman, who said she was the sole person supporting her special needs son, talked about having to put her house on the market to recover from the losses. This is not a way you want to live your life. There is no need for it, especially when using margin is simply an attempt to get rich faster.

How to Avoid Margin Calls

There are two primary ways you can avoid a margin call.

  1. Open a “cash only” account at your brokerage firm. Aside from being a little more inconvenient, it not only means you can’t create margin debt (securities must be fully paid, in cash, at the time of acquisition), but also that you can insulate yourself from a remote-scenario rehypothecation disaster in which your assets are seized to pay the debts of your brokerage firm if the broker goes bankrupt. If you want to employ leverage within a cash account, you can still gamble with stock options that are fully paid or take advantage of 3x leveraged ETFs. For example, instead of shorting a stock, you might buy a put option, instead. It has different risks and trade-offs but the most you can lose is 100% of the amount you spent on the put premium.
  2. Only take positions that have a theoretical maximum loss and keep that amount of money, plus a 10% or 20% cushion for interest or other contingencies, parked in an FDIC insured bank account or in U.S. Treasury bills. That way, no matter what goes wrong, you know you can cover the worst-case scenario payment. Remember, however, that the broker may not give you a chance to meet the margin call if they are sufficiently worried, liquidating your positions before you’ve been contacted.

Also, realize you are probably going to get slightly better treatment from a private bank or full-service broker than you are a discount broker. There are no free lunches in life. If you had a margin call but it was a tiny percentage of your net worth, and you had most of your net worth invested or parked in the private bank that served your brokerage needs through an affiliate, the private banker might find a way to avoid having your holdings sold off or inconveniencing you by giving you a courtesy phone call. They don’t have to do it, and you should never assume they will, but it’s possible they aren’t going to want to lose a rich client who pays a lot of lucrative fees for white-glove service over a relatively paltry sum. It’s delusional to think you’re going to get a courtesy like that at a barebones discount broker operating a do-it-yourself account so be particularly careful if you’re working on your own.

What Is a Margin Call and What Happens If I Get One Conclusion

For more information about currency trading brokers visit TopForexBrokers.com Forex brokers comparison website, Tip ForexSQ.com foreign exchange trading experts please by share this article about What Is a Margin Call and What Happens If I Get One.

In this article