Margin Call is one of those stock market terms that are mostly incorrectly understood by the traders and investors.
In this review, we will have a quick look at some of the basics related to this concept apart from answering some of the most frequently asked questions about it.
Margin trading is the process by which the trader is able to borrow funds from the brokers and use those funds to purchase securities. This form of trading provides the traders with leverage to be able to buy more securities than they can otherwise afford at any point in time.
Even though the trader is borrowing funds, he has to pay some part of the total value of securities with his own money. The part of the value of securities paid by the trader himself is called Margin Money. A trader requires a margin account into which the money is to be deposited.
As soon as the margin account is opened, the trader needs to deposit some money into the account before he starts trading on margin. This type of margin money is called the initial margin money, and minimum margin money is the fixed minimum amount that has to stay in the trader’s margin account throughout the trade over and above the difference between the value of the securities and the loan.
As soon as the money in the margin account starts going down and reaches the minimum margin level, the dreaded Margin Call is made to the trader by the broker.
Margin Call is, therefore, the demand made by the broker to the trader to deposit additional cash or securities to his margin account so that the balance in the margin account reaches back the minimum margin requirement. This happens when the trade has lost so much money that the broker fears that the trader will not be able to pay it off. It is a warning to the trader and a protection to the broker.
Margin Call may be a telephone call, like in olden days, or the broker may just square off the trade to reduce the losses which leave the trader with more loss than anticipated as he did not get a chance to cover up for his losses. Margin Call is not a good situation and should always be avoided.
If a trader receives a margin call, it means that the trader was unable to manage his trade properly and ended up in huge losses.
Margin Call Mechanism – Example
Let’s understand the concept even more clearly with the help of an example:
A trader opens a margin account with initial margin requirement as 8% and minimum margin requirement as 4%.
He wants to buy 100 shares of Reliance Industries at ₹960 per share. So, the total capital required is 100*960= ₹96,000.
The trader deposits 8% of ₹96,000 = ₹7680 as initial margin and starts trading.
The next day, the price of Reliance shares falls by 5%. In this case, the trade-off of 8%-5%= 3% is less than the minimum margin requirement of 4%.
At this point, a margin call is triggered to the trader by the broker and the trader must provide additional cash or securities worth 1% of the trade= ₹960 so that the margin account balance is able to reach back to the minimum margin requirement.
Why is Margin Call so dreaded?
Margin Call is taken very seriously by the brokerage firms, government, regulators and the traders. For the lenders, they serve as the protection mechanism against losses. The traders should avoid margin calls for the following reasons:
Margin Call is an unpaid debt. These unpaid debts are reported to credit agencies and may affect the credit score of the trader negatively.
The brokers may also file a lawsuit against the borrower in the event of non-payment of additional margin money, demanding immediate repayment.
So, the borrower, first of all, tries to avoid getting a margin call by trading efficiently, and in unavoidable circumstances of having received a margin call, the debt must be paid as soon as possible to avoid further damage.
Margin Call – How to Avoid it?
As we have understood, a margin call is the last thing a professional trader will want to face. It is mostly the result of a lack of knowledge and experience, and sometimes, due to the spontaneous emotions that the trader gets caught in. In order to avoid a margin call, a trader must:
Understand the margin call mechanism.
Know in detail the initial margin and minimum margin requirement of a broker before entering into a trade.
You may choose to deposit a relatively higher value as the initial margin as compared to the value provided. This will assist you in keeping the difference between the initial margin and the loss%age higher than the minimum margin percentage (like 8% we took in an example above).
Use stop loss orders to ensure the losses do not go below the margin call level.
Manage emotions so that excessive greed and fear do not cloud judgement and force the trader to take huge risks and bear huge losses.
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