What are margin calls?

In the world of finance and trading, margin call is a term that comes up fairly regularly. It is an essential concept for traders who use leverage in their investments and trading activities. A margin call occurs when the trader's account value falls below the minimum margin requirement. If your account does not have sufficient funds to cover the cost it can be serious to receive a margin call, meaning that, among other things, other positions may be liquidated to cover it. Understanding what a margin call is and how it works is crucial for investors and traders to manage their risk and avoid potential financial losses. It is also important for financial regulators and policymakers to monitor margin levels and prevent excessive leverage, which can contribute to market instability. This article will explain the textbook margin call definition, the margin call calculation method and what happens if you are unable to cover a margin call. 

What are Margin Calls?

A margin call is a demand from a broker or a lender for a trader to deposit additional funds or securities to cover losses that may have occurred due to a decline in the value of their trading portfolio. In trading, margin refers to the amount of money or securities a trader borrows from a broker to trade in financial markets. Traders typically use margin to amplify their profits, as they can buy more securities than they would be able to with their own funds. However, the use of margin also increases the risk of losses. 

When a trader's account falls below a certain level, known as the maintenance margin, the broker may issue a margin call. This happens when the value of the securities purchased with borrowed money declines, and the trader is no longer meeting the minimum equity requirement. The broker will demand that the trader deposits additional funds or securities to cover the shortfall. 

Margin calls are not uncommon in trading, especially in high-risk investments such as CFD trading. They are designed to protect the broker from potential losses and to ensure that traders maintain a certain level of financial responsibility. It is important for traders to monitor their margin levels and to have a plan in place to respond to margin calls in order to avoid potential losses. 

How do you Calculate a Margin Call?

The calculation of a margin call depends on several factors, including the size of the trader's position, the leverage ratio, and the market price of the asset in question. The formula for calculating a margin call is as follows: 

The "Current Market Value of Position" refers to the current market price of the asset multiplied by the size of the trader's position. The "Initial Margin" is the percentage of the total value of the position that the trader is required to deposit as collateral. The "Margin Requirement" is the percentage of the total value of the position that the broker requires the trader to maintain as collateral. 

For example, let's say a trader opens a position with a total value of $10,000 and a required initial margin of 10% ($1,000). The broker also requires a maintenance margin of 5% ($500). If the current market value of the position falls to $8,000, the margin call would be calculated as follows: 

Margin Call = ($8,000 - ($1,000 * $10,000)) / (1 - 0.05)

Margin Call = ($8,000 - $10,000) / 0.95 Margin Call = -$2,105.26 

In this scenario, the trader would need to deposit an additional $2,105.26 into their margin account to meet the broker's margin requirements and keep the position open.

What Happens if I Can't Cover a Margin Call? 

If a trader fails to cover a margin call, the broker may take several actions to recover the money owed. It is important to understand the negative consequences and extent of potential losses before making any financial decisions, but particularly when it comes to margin trading as the trading outcome can be exceptionally negative if risk is not properly managed. 

The first thing a broker may often do is liquidate some or all of the trader's other positions in order to cover the margin call. This means selling the trader's securities or assets to raise cash to cover the shortfall. The broker will typically sell the securities that have declined in value the most, which may result in a loss for the trader if these positions have not yet reached maturity according to the trader’s strategy.  

The broker may also issue a legal claim against the trader for the amount owed if the margin call is not able to be covered by liquidated positions. This may involve taking legal action to recover the funds owed, which can result in additional fees and costs. Finally, the broker may report the trader's failure to meet the margin call to credit reporting agencies, which can damage the trader's credit score and make it difficult to obtain credit in the future. 

Once again, it is very important for traders to understand the risks involved in margin trading and to monitor their accounts regularly to ensure they have sufficient funds to cover margin calls. If a trader is unable to cover a margin call, it is important to contact the broker as soon as possible to discuss options for resolving the issue. 

Conclusion

In conclusion, a margin call is a demand for additional funds or securities to cover losses in a trader's account due to a decline in the value of their trading portfolio. The use of margin increases the risk of losses, making it important for traders to monitor their margin levels and have a plan in place to respond to margin calls. The calculation of a margin call depends on the size of the investor's position, the leverage ratio, and the market price of the asset in question. If a trader cannot cover a margin call, the broker may liquidate the trader's other positions, issue a legal claim, and report the trader's failure to meet the margin call to credit reporting agencies, resulting in additional fees and costs. Thus, understanding margin calls is crucial for investors and traders to manage their risk and avoid potential financial losses.