Volatility is back, and market swings can sometimes bring an uncomfortable surprise to investors: a margin call.
When you buy stock on margin, your brokerage firm lends you cash, using assets in your account as collateral, to purchase securities. To trade on margin, you must have a margin account with your brokerage firm. There is a difference between a margin account and a cash account. In a cash account, all transactions must be made with available cash, while a margin account allows you to borrow against the value of the assets in your account to purchase securities.
Though using margin increases your purchasing power, there's a flip side to buying with borrowed funds. Not only do you pay interest on the money you borrow, but buying on margin leaves you open to the potential for larger losses. In fact, you can even lose more money than you invested.
If the securities you're using as collateral go down in price, your firm can issue a margin call. This is a demand that you repay all or part of the loan with cash, a deposit of securities from outside your account, or by selling securities in your account.
How you could get "the call"
There are a few ways to end up with a margin call. First, if the assets in your brokerage account fall below the "initial margin requirement" for a stock you purchased, you can get a margin call.
In general, under Federal Reserve Board Regulation T (commonly referred to as Reg T), firms can initially lend a customer up to 50% of the total purchase price of an eligible stock. But in some cases, a firm might restrict you from purchasing or owning certain securities on margin. This can include stocks that do not trade on a national exchange such as the NYSE or NASDAQ, and might also include stocks the firm believes to be particularly susceptible to price swings.
For example, let's say you buy $10,000 worth of a stock on margin. Under Reg T, you have "one payment period," which works out to be four business days from the trade date, to meet the initial margin requirement of $5,000 -- 50% of the total purchase price. However, the firm may shorten the payment period and may require you to deposit a higher initial margin amount.
If you don't meet this deadline, regardless of whether the stock you purchased on margin moves up or down, you will get a margin call requiring you to deposit the 50% of the purchase price ($5,000). While a firm may grant an extension, it is not required to do so. If you fail to make your deposit, and the firm does not grant you an extension, the firm is required to liquidate the shares you purchased on margin, or it can liquidate other assets you put up as collateral.
An important side note: When you open a margin account, FINRA rules require you to deposit a "minimum margin" amount of $2,000 with your brokerage firm, but this may not be enough to cover your initial margin requirement.
A second way to get a margin call is if your account's assets fall below regulatory and firm "maintenance" margin requirements.
The rules of FINRA and U.S. securities exchanges supplement the requirements of Reg T by placing "maintenance" margin requirements on customer margin accounts. As a general matter, a customer's equity in a margin account must not fall below 25% of the current market value of the securities in the account.
Firms may also set margin requirements of their own -- often called "house" requirements -- that can be higher than the margin requirements under Reg T or the rules of FINRA and the exchanges. For instance, a firm may set the maintenance margin at 30% or even 40% of the current market value of the securities in your account. Furthermore, firms can increase the "house" requirements at any time and are not required to provide you advance written notice.
If your margin account falls below regulatory or firm maintenance margin requirements, you will end up with a maintenance margin call. In this case, you must put more money into the account to meet the required level, or the firm will likely force the sale -- or liquidation -- of some or all securities in your account to bring the account's equity back up to the required level.
And here's an important reality check: A firm is not required to notify you of the sale, though most do so as a courtesy, nor does the firm let you choose which securities or assets are sold to meet a margin call.
Read and monitor
Here are actions to help you understand what triggers a margin call -- and, by extension, avoid or prepare for one.
Read your margin agreement. Your financial firm's margin agreement may be a part of a general brokerage agreement or it may be a stand-alone agreement. Either way, read the margin disclosure information carefully. It's here that the terms and conditions of margin loans are explained, and how the securities you purchase serve as collateral. Regulatory requirements and a firm's own margin requirements are also explained. Pay particular attention to "minimum margin." Also see if your firm might issue an intraday margin call instead of only at market close -- for instance, after a big intraday dip in the market. This is sometimes referred to as "real-time margin."
Monitor your maintenance requirement. Fully understand your firm's maintenance requirements. Does it use the FINRA minimum requirement of 25% of the current market value of the securities in the account, or is the requirement set at a higher level? Know the price or prices that, if reached, are likely to trigger a call. If you aren't sure how a maintenance call might be triggered, ask a brokerage firm representative to paint a scenario or two.
In short, know the rules -- and stay abreast of market conditions to monitor when you might be getting close to a margin call. You might not be able to avoid the call, but at least it won't come as a big surprise.
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