Buying on margin involves taking out a partial loan from one’s broker in order to cover a larger investment than one’s capital could directly cover. A margin call most often occurs when the amount of actual capital the investor has drops below a set percent of the total investment. A margin call may also be triggered if the broker changes their minimum margin requirement —- the absolute minimum percentage of the total investment that one must have in direct equity. Some examples will best demonstrate the two circumstances in which a margin call is likely to occur.
Let us assume that we go through our broker to purchase $100,000 worth of stocks. We’ll say that we borrowed $50,000 from our broker on margin to purchase the stocks, and invested $50,000 of our own capital. After a particularly poor week of performance, the stock we initially invested in is now worth only $75,000. This leaves our equity at $25,000, which we can determine by taking the current value of $75,000 and deducting the loan value of $50,000. If our broker’s minimum margin requirement is 30%, we will still be fine, as the minimum margin requirement in our case would be 30% of $75,000, or $22,500.
If, however, the value of the stock drops again the next day to $60,000, then our equity will be left at a mere $10,000. At this point, our broker will put out a margin call, and we will be forced to raise at least an additional $8,000. We might raise the money to meet the margin call by selling off a portion of the stock we have invested in, by taking out an additional loan from another source, or by replenishing our equity pool with our own assets.
The second scenario in which a margin call might occur has to do with the brokerage itself, rather than the performance of the market. Let us assume the same situation as before, in which we have purchased $100,000 worth of stocks with $50,000 in equity. The same initial downturn occurs, leaving us with $25,000 in equity on a $75,000 investment. This same brokerage has a minimum margin requirement of 30%, so they have no need to issue a margin call.
Occasionally, however, because of the swinging market or internal factors, a brokerage may decide to adjust their minimum margin requirements slightly. If our brokerage were to raise their minimum margin requirement to 35%, the minimum equity in our case would be $26,250, so we would be issued a margin call and be forced to raise an additional $1,250. A margin call is not a big deal in the financial world, and it does not reflect poorly on an investor to be subject to one. Margin calls are simply a part of buying on margin, and while some people choose to keep their invested equity well above the minimum margin requirements to avoid a margin call, others keep themselves continuously invested at exactly the minimum, prompting a margin call every time the market takes a downturn.