What is Margin call?

If you are a trader then you would definitely have had more than one occasion of receiving an email from your broker for a margin call. But for a new trader, this term may need some context and a deeper understanding of not only the price and volume movement of the securities but the market in general as well. So what is the meaning of margin call and why is it important in trading? Read on to know more about margin calls and what role they play in a trader’s portfolio.

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What is margin trading and the meaning of a margin call?

Creating a successful trading portfolio and the ability to generate higher returns requires huge capital. This is often one of the biggest deterrents for many traders from venturing into stock trading. However, brokers can come to your aid by offering funds to traders as a margin in exchange for collateral. This is known as margin trading where the traders are allowed to borrow money from the brokerage firm to trade in different securities like stocks, bonds, or commodities. However, margin trading involves many risks and one of them is margin calls. 

A margin call is when there is a decrease in the value of investments below the maintenance margin and the amount borrowed from the broker is quite high in proportion to the value of investments. The meaning of the margin call is the request or rather a demand from the broker to deposit more money into the trading account to cover the losses and reduce the borrowed amount.  

How does margin call work?

To understand how the margin call works, it is important to understand the basic terms associated with margin trading. This includes the initial margin and maintenance margin. The initial margin is the minimum amount of equity that you should have in your trading account to initiate margin trading. This initial margin is proportionate to the percentage of the total value of investments that a trader aims to purchase. For example, if the trader wants to purchase securities worth Rs. 1,00,000, they have to provide an initial margin of 50% i.e., Rs. 50,000 in the trading account. 

Following this, once the trader starts margin trading, they have to maintain the minimum level of margin in the trading account known as the maintenance margin. This margin is lower than the initial margin and usually is 25% of the value of the investments or depending on the individual policies of the broking firm. The broker issues a margin call when the value of equity in the trading account is lower than the maintenance margin. 

Let us consider the following example to understand when the margin call is triggered. 

Consider Trader A engaging in margin trading with Firm XYZ which has set the initial margin at 50% and the maintenance margin at 25%. Therefore, if Trader A wants to purchase securities worth Rs. 2,00,000, they have to provide an initial margin of Rs. 1,00,000. The balance of Rs. 1,00,000 is lent by the broker in the form of debt. Let us assume there is a significant downturn in the portfolio value and it is reduced by 40% to Rs. 1,20,000. The maintenance margin, in this case, will be Rs. 30,000 (25% of 1,20,000). The revised value of equity will be Rs. 20,000 (120000-100000). Therefore, a margin call of Rs. 10,000 will be immediately triggered as the value of equity fall below the maintenance margin. 

What action is to be taken upon getting a margin call?

When the margin call is triggered, the broker sends a notice regarding the same to the trader via SMS or email, or both. Upon receiving this email, the trader will have to arrange to deposit the balance of funds in the trading account. Traders usually have a grace period of typically 3 days to deposit the balance amount. This grace period can vary from broker to broker depending on their individual policies. If the required funds are not deposited within the prescribed grace period, the brokerage firm has the authority to safeguard its interests. The firm, in such cases, could opt to sell a portion or all of the investor’s securities in order to decrease the borrowed amount and restore the account’s compliance with the maintenance margin requirement.

Can margin calls be avoided?

We have seen above, the consequences of not depositing the required funds into the trading account when the margin calls are triggered. Furthermore, many traders also levy a nominal penalty for not taking timely action and multiple events of such penalties can eventually eat into the trading profits for the traders. Therefore, it is important for traders to avoid margin calls. Here are a few steps that traders can take to ensure they do not trigger margin calls and can safeguard their portfolios.

• Maintain sufficient cash reserve to avoid triggering margin calls
• Ensure sufficient diversification of the portfolio to provide a hedge against potential losses and reduce the risk of declining the overall value of assets in the portfolio.
• Liquidating loss-making securities to protect the account balance and reduce the possibility of further losses. 
• Traders can set their personal trading margin that is higher than the maintenance margin of the broker so the trader is aware of the possible trigger of margin call and can take suitable steps.
• Trade in high-volatility stocks on margin with caution for reducing potential risks. 
• Regular monitoring of trading portfolios can help in identifying potential reductions in the value of investments and taking timely actions. 

Conclusion

Margin calls are the warning call issued by the broker to safeguard their interest as well as caution the trader from incurring further losses. However, they can be a recurring event in a falling market. Therefore, it is important for traders to understand the concept of margin calls and to take suitable steps to avoid them. 

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