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What Happens When You Get a Margin Call

Sebencapital

Published
17/01/24
What Happens When You Get a Margin Call

Facing a margin call can be a significant challenge for traders. However, you can avoid a lot of problems by understanding how margin accounts function. Take some time to learn and be proactive in preventing issues, saving yourself trouble in the future.

How Does Margin Debt Work?

from them later. You secure this loan by using the cash and securities in your account as collateral. If you borrow money to buy investments and the value drops, the broker can sell your other assets to cover the loan, which can be a big problem.

If your account doesn't have enough value to cover the loan, you're on the hook for the entire debt amount. This means you can lose more money than you initially put into your account. Trading with borrowed money, or on margin, comes with risks.

When you trade on margin, there's a chance of getting a margin call. This happens when the equity in your account falls below certain limits compared to the debt. The broker will ask for a quick solution, like depositing more money, selling investments, or both.

Triggering Margin Calls

Your account might dip below the rules for margin debt set by regulators. This can happen because of changes in asset prices or new regulations. The Federal Reserve's Regulation T allows the central bank to enforce rules on how much debt you can have compared to your equity. It's a way to prevent too much risky speculation.

For instance, the current rules for buying stocks on the New York Stock Exchange say you need at least 50% equity when you make a purchase. You also have to maintain 25% equity in your account at all times. So, if you had $100,000 in your account, you could borrow an additional $100,000 on margin, making your total assets $200,000—half debt and half equity. A margin call might not happen until your account balance drops by about 33.33% to $133,333. At that point, the debt would be 75% of the total account balance.

Note

There are additional restrictions on margin debt. For instance, there's a limit for accounts with less than a certain size, typically around $2,000, or when trading what are known as penny stocks.

Brokerage Firm Rules

You might face a margin call if your brokerage changes its rules for your account. This could happen if they think you're not a good risk anymore or if it's related to a specific investment you own. There are various reasons why they might alter their policy, and it may not always be fair or in your best interest. Some brokerage firms set higher margin maintenance requirements than the minimum rules set by regulators.

Brokers want to avoid the risk of you not being able to repay borrowed money, so having a larger cushion of equity to absorb losses makes them feel safer. Remember, the broker can demand payment at any time without giving you notice, as they have the discretion to decide about margin debt.

If your account no longer meets the required equity-to-debt ratio, the broker will issue a margin call.

Getting a Margin Call

If you get a margin call, nowadays, it often shows up as a big notice on the broker's website when you log in to check your account. If the broker isn't too concerned, they might give you some time to add new money or securities to your account and increase the equity value.

But if the situation is more serious, the broker might start selling off your investments to get cash. The broker's main concern is protecting its own financial health, and they don't want to chase you down for money owed. They're not obligated to give you time to meet a margin call, and they can sell your assets without consulting you.

You might not have a chance to fix things. When you opened your account, you agreed to the terms in the account agreement, which clearly explained the consequences of a margin call. So, you have to deal with the outcome.

Note

Your broker has the authority to sell your investments, even the ones that have gained a lot in value. This might lead to significant deferred-tax obligations and result in substantial capital gains taxes for you. Additionally, they can also sell your investments that are currently worth much less than what you paid, potentially locking in your losses at the worst possible time.

Not Meeting a Margin Call

A margin call is a serious matter, especially if it results in debts you can't afford. If you can't meet a margin call and your assets have been sold to cover the debt, the remaining balance turns into an unsecured debt in default. This can potentially impact several aspects, among other things.

Credit Score

Failing to handle the debt after a margin call can cause problems. It gets reported to credit agencies, making it tougher to borrow money and affecting your credit score. Other lenders might stop providing their services; for example, a credit card company could close your account or increase your interest rates to manage risks.

If you have business loans, the full amount owed may become due. Additionally, finding a new job might be harder in some states, as employers are allowed to check credit histories for new hires.

Insurance Rates

Failing to address the debt from a margin call can lead to a universal default. This could result in higher insurance rates for your home, cars, or other policies in states where such increases are allowed.

Lawsuit

If you can't pay back the debt from a margin call, the broker might take legal action, suing you for immediate payment, including legal costs. The available solutions depend on your state's laws, but they might include requiring you to reveal your entire financial situation under oath, which involves disclosing:

  • Income
  • Assets
  • Debts

If you can't pay the debt, your bank accounts and personal property might be taken or sold, and even real estate investments could be put up for sale.

Best Options

If you're facing a difficult financial situation due to a margin call, one option is to gather funds quickly, even if it means selling assets like cars or furniture. Another choice is to consult with a bankruptcy attorney promptly. If bankruptcy seems like the right solution, they might recommend doing it sooner rather than later.

While bankruptcy can be challenging, it may help protect the money in retirement plans like your 401(k), 403(b), Roth IRA, as they are often out of reach for creditors. If you use these accounts to cover a margin call, you'll face ordinary taxes and an additional 10% penalty tax. If the liquidated funds aren't enough to cover the entire debt, bankruptcy might still be a necessary step.

Avoiding Margin Calls

To avoid margin calls, it's a good idea to open a cash-only account with your brokerage. Although it might be a bit less convenient, this type of account prevents you from creating margin debt because securities must be fully paid for in cash when you purchase them. If you still want to use leverage in a cash account, you can consider investments like fully paid stock options or 3x leveraged ETFs.

For example, instead of shorting a stock, you might choose to buy options on that stock. Put options have their own risks, but the maximum you can lose is 100% of the amount you spent on the cost of the puts.

Another approach is to only take positions that have a maximum theoretical loss. Keep that amount of money, plus an extra 10% to 20% for interest or other potential issues, in an FDIC-insured bank account or U.S. Treasury bills. This way, you ensure you can cover the worst-case scenario payment.

Note

Brokerages may sell your investments without warning, even before notifying you about a margin call.

The Bottom Line

You might receive better treatment from a private bank or full-service brokerage compared to a discount brokerage. If a margin call is a small part of your overall wealth, they might try to avoid selling your holdings by giving you a friendly phone call.

However, brokerages are not obligated to notify you, so never assume they will. They might not want to lose a high-paying client for a small amount. If you're using a discount broker and managing things on your own, don't expect a courtesy call, so be cautious.

Frequently Asked Questions (FAQs)

1. When does a margin call occur?

A margin call happens when the money in your account drops below what your brokerage says is the minimum needed to keep it going. There are legal minimums set by regulators, but your brokerage might use an even higher amount. It's a good idea to ask your brokerage about their specific rules for this.

2. How long do you have to cover a margin call?

When you get a margin call, it's up to the brokerage to decide how much time you have to fix it. The time given might depend on the amount you owe, but usually, you can expect to have two to five days to cover the margin call.

Written by Sauravsingh

Techpreneur and adept trader, Sauravsingh Tomar seamlessly blends the worlds of technology and finance. With rich experience in Forex and Stock markets, he's not only a trading maven but also a pioneer in innovative digital solutions. Beyond charts and code, Sauravsingh is a passionate mentor, guiding many towards financial and technological success. In his downtime, he's often found exploring new places or immersed in a compelling read.

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