In my previous life as a hotel manager a co-worker and I used to enjoy bantering about our adventures and misadventures in investing. I remember one such conversation in early 2009, during the worst of the great recession, when he was complaining about all the margin calls he received the previous days. Today I will be explaining what a “margin call” is and why it happens.
(This post is the second of three posts on “trading on margin”. For a refresher on “margin” check out the link)
When you buy some stocks on margin, (like the example from the last post), the margin is called “initial margin”. Let’s say the “initial margin” is 50%.
Let’s start with our example:
I buy 40 shares of Microsoft at $25. I would therefore be buying $1,000 worth of shares (40 X $25 = $1,000).
The “initial margin” is 50%, so I only have to deposit 50% of the value ($500) and the broker will lend me the other half ($500) to buy the shares.
To protect the markets from excess leverage, the authorities have instituted “maintenance margin”. “Maintenance margin” is the amount of cash you have to have in the position, at a minimum, if the price goes down. Remember, if you borrow money and the position goes down you still owe the broker the same amount.
In our example, if the Microsoft shares drop to $20 per share, out position would now be worth $800 (40 shares X $20 per share). We would still owe our broker $500, though, so our own “equity” would now be $300 ($800 position – $500 borrowed).
This is where “maintenance margin” comes in.
Our “equity” in the position would now be 37.5% ($300 of our own money divided by $800 total position = 300/800)
Let’s say the “maintenance margin” is 30%. This means that the minimum amount of equity we need to have is 30% of the position value.
Let’s say, Microsoft drops to $16 per share. Our total position would now be worth $640 (40 shares X $16). We still owe the broker $500, therefore our equity is now $140 ($640 – $500). This represents a margin of approximately 22% ($140 equity / $640 total position). This is below the minimum equity in the position, the maintenance margin, of 30%, therefore will receive a “margin call”.
“Margin call” is when the broker contacts you to either
* sell some of the position, or
* deposit cash, or
* deposit other securities
so that the margin in your account goes back to 30%. (The value of your equity, divided by the value of the total position must be greater than 30%.)
Therefore we either:
* deposit $52 into our account which brings our equity to $192 and the margin to 30% ($192 equity / $640 position = 30%) [because 30% of $640 is $192], or
* sell $174 of Microsoft stock, therefore our total position would now be $466 ($640 – $174) and therefore our margin would be approximately 30% ($140 equity / $466 total position), or
* deposit other securities to get to a margin of 30%
As you can imagine, getting a margin call can be quite traumatic, since you are watching the value of your investments drop, while being asked to deposit more and more money into you account – the so-called: “throwing money in a black hole” scenario.
In my next post (the third in this series) I will discuss the implications of trading on margin and what this means to your investment strategy and on your investments results.
Kevin Mzansi
Image by photoloni
