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Individuals actively participating in the stock market or trading understand the importance of grabbing the best opportunities for maximum gains. Margin trading is an excellent avenue for empowering an investor with ample opportunities and aiding them to make the most of them. Nevertheless, this facility, too, despite its benefits, has several challenges, including a margin call.
The margin call safeguards you and the broker from significant losses. It usually happens when the investment’s value drops below a specific margin call and stop-out level. This prompts a broker to request extra funds to preserve the necessary margin.
This blog will highlight the meaning of a margin call, its importance and how to avoid a margin call.
What Does A Margin Call Imply?
The margin call usually occurs when an investor’s equity percentage in a margin account goes below the required amount of the broker. The margin account of an investor
A margin call occurs when the percentage of an investor’s equity in a margin account falls below the broker’s required amount. Securities purchased using a combination of the investor’s funds and funds borrowed from the investor’s broker are kept in an investor’s margin account.
In particular, a margin call is when a broker requests that an investor add more funds or securities to the account in order to raise the investor’s equity value as well as the account value to the minimum amount specified by the maintenance requirement.
When Does a Margin Call Happen?
Usually, a margin call occurs when the market unexpectedly turns against your investments or trades. This abrupt change might be the consequence of a number of things, including developments in the economy, geopolitics, or market mood. The broker swiftly issues a margin call when the value of your investments drops and exceeds the maintenance margin requirement.
It’s critical to understand that trading has risks by nature and that market volatility may be extreme. Because of this, traders frequently experience margin calls, mainly when using highly leveraged positions. A margin call can be frightening and, if not handled well, might result in considerable losses. Understanding the right strategies may help you save money while also improving your trading experience. Take a look at this margin call futures example:
For instance, let’s say the broker establishes the initial and maintenance margin at 50% and 25%, respectively. Suppose you purchase securities worth Rs 10,000, with the initial margin set at Rs 5,000 (50%), resulting in a margin debt or broker-lent amount of Rs 5,000. The maintenance margin is then Rs 2,500.
Now, if the securities’ value depreciates by 40%, your portfolio value will decline to Rs 6,000. Consequently, the maintenance margin drops to Rs 1,500 (25% of Rs 6,000). At this point, your equity stands at Rs 1,000 (Rs 6,000 – Rs 5,000). Since the maintenance margin should be Rs 1,500, you’ll need to take necessary measures to raise Rs 500.
When the equity value falls below the maintenance margin, it is referred to as a margin call analysis. If the equity decreases to zero, the broker won’t issue a margin call but will instead sell the securities held as collateral to recover the debt.
Importance of a Margin Call
Since it plays such a vital role in risk management, market stability, and investor and broker protection, margin calls are significant in the financial world. Among its principal advantages are:
Risk Management
For investors who trade on margin, margin calls are an essential part of their risk management strategy. Margin calls serve as a safety net by requiring more cash when the value of investments drops below a specific margin call and stop-out level. They keep investors’ losses from exceeding their original investments and guarantee that the risks attached to leveraged positions are contained within reasonable bounds. This feature is significant in unpredictable markets where asset prices can change drastically quickly.
Protecting the Broker
A margin call analysis safeguards the broker as well as the interests of the investor. By offering leverage, brokers enable margin trading, enabling investors to manage greater holdings with comparatively less cash. The protection of the broker’s financial interests is guaranteed via margin calls. They serve as a safeguard for the money given to the investor and reduce the possibility that the broker would suffer losses as a result of the investor’s leveraged holdings.
Market Stability
A significant factor in preserving the general stability of the market is margin calls. They keep investors from taking on more risk than they can manage by discouraging excessive speculation and the use of excessive leverage. Without margin calls, markets could be more prone to abrupt, steep drops, which could raise volatility and even cause financial institutions to collapse. Margin calls’ preventative aspect helps create a more stable and equitable trading environment.
Preventing Forced Liquidation
When investors don’t satisfy their margin requirements, brokers may be obliged to sell assets for a forced price in the absence of margin calls. Before taking such extreme actions, investors might add more money to their accounts through margin calls. By being proactive, you can lessen the likelihood of forced sales, which may intensify market downturns and cause worse disruptions.
How Can You Avoid Margin Calls?
You do not need to be concerned about the margin call when you do not have a margin account. To know how to avoid a margin call, you can take the following actions if you do have a margin account.
Have Additional Cash On Hand
To prevent a margin call, retain some extra cash in your account rather than investing it all. This is seen as a smart choice since money has a fixed value, unlike the value of stocks, which varies.
Limit Volatility By Diversifying Your Portfolio
You have a variety of alternatives as an investor, including stocks, bonds, commodities, and margin call derivatives. Buying a variety of assets will help you diversify your holdings. The likelihood of falling below the maintenance margin and maybe prompting a margin call will be reduced with the aid of diversification.
Monitor Your Account Regularly
Although you do not need to continually check your portfolio, if you have a margin account, you should track it on a daily basis. It will keep you informed of whether you are approaching the maintenance margin, allowing you to take appropriate action right now.
Set Your Limit
To successfully prevent a margin call, you can set your maintenance margin above and beyond the exchange. Once your account has reached that limit, you can make additional deposits to avoid a margin call. In this manner, you can avoid selling assets in a rush to meet maintenance obligations.
Bottom Line
Purchasing shares on margin is not advisable for most individuals who are investing for a long-term objective like retirement. A margin call analysis will require you to increase your account equity, either by adding more cash and securities or by selling current assets. Since margin calls frequently occur during times of significant volatility, you may be compelled to sell stocks at low prices.
FAQs
The amount of money you need to put into your trading account in order to open a new position is known as the initial margin. The minimal balance required to avert a margin call is known as the maintenance margin.
If you get a margin call, you will still be able to trade the positions you currently have open, but you will need to make further deposits right away to get your trading balance down to the required maintenance margin. If you are unable to accomplish this, the broker may liquidate all or part of your holdings in order to meet the margin requirements.
When there is a margin shortfall in the trader’s margin account, the broker issues a margin call. The trader must either sell some assets in the margin account or deposit cash or marginable securities there in order to make up for a margin shortfall.
A margin call needs to be paid out right now without exception. The fine print of a typical margin account agreement will typically state that the broker has the right to liquidate any or all securities or other assets held in the margin account at its discretion and without prior notice to the trader in order to satisfy an outstanding margin call, even though some brokers may give you two to five days to meet the margin call.
A significant amount of margin debt may increase market volatility. During sharp market drops, customers are required to sell equities to make margin calls. This can create a vicious spiral in which heavy selling pressure drives stock prices down, resulting in additional margin calls and selling.