Movies about the stock market will often talk about margin calls, puts, and leverage. For the average person, these terms can feel overly complicated. By learning what a margin call is and how it affects the stock market, individuals can become better investors and more knowledgeable about the financial marketplace.
What Is a Margin Call?
So, what is a margin call? According to the financial experts at SoFi, “A margin call happens when a brokerage firm says that an investor needs to add funds to their account.” When someone trades with a margin account, they basically get to purchase extra stocks, bonds, and other financial vehicles using leverage.
For instance, an investor may have just $500 to spend on stock. They want to buy $1,000 worth of the stock, so they create a margin account. The broker loans them the additional $500, which allows them to trade with a 50 percent margin.
The investor is hoping that the stock will rise in value. If that happens, they will be able to sell the stock and keep the profits from all of the shares. Unfortunately, the stock can also lose value. When this happens, the investor has margin debt.
When Does a Margin Call Happen?
When do brokers issue margin calls? In general, a margin call occurs when the account’s value drops below a set threshold. When this occurs, the investor must add more money to keep the broker happy. If the investor cannot satisfy this margin call, then the broker can sell off the investor’s positions. They can also charge the investor fees, interest and commission.
Margin calls operate around an idea known as leverage. In essence, leverage allows people to achieve larger positions than they can afford on their own. As a result, it is possible for investors to win and lose more than they would normally be able to.
Normally, the minimum margin requirement is determined by an exchange. The financial vehicle’s volatility is one of the factors that the exchange will consider. In addition, the exchange may change margin requirements because of supply changes, shifts in demand, or geopolitical events. For securities, the maintenance margin is generally placed at a minimum of 25 percent.
How to Prevent a Margin Call From Happening
When someone uses leverage, they can potentially lose their entire investment. Normally, investors can at least recuperate some of their losses by selling the stock they own. Leverage allows investors to take larger positions than they can actually afford, which means their losses can quickly add up to their total investment amount.
To avoid losing money with a margin call, the easiest option is to avoid getting a margin account. Professional traders can get in trouble with margin accounts, so beginning traders can quickly encounter major problems. If someone is determined to start a margin account, they can avoid a margin call by diversifying with less volatile investments, keeping extra cash on hand and following the trajectory of their account.
While leverage can increase the profits a trader receives, it can also increase their risks. This is especially true when the market is unusually volatile. By learning about margin calls and how leverage works, investors can learn how to prevent some of these losses from happening.