What is a Margin Call?

In the stock world, many experienced investors opt to buy some stocks on margin. Buying stocks on margin is an attractive option for investors as it allows them the opportunity to double their return. When an investor buys stocks on margin, he pays for a fraction of the stock, usually around 50% (but it cannot go beyond this), and then borrows the rest from his broker. Buying stocks on margin can result in a large return when the stock goes up and allows you to purchase more stocks by using the assets you already have as collateral for the loan. In addition, it also lets you to react quickly to new investment opportunities because you have the added money in your account.

Buying on margin works something like this- First, your broker will set you up with a margin account. Let's say you put $5,000 in it. That gives you $10,000 of buying power, since you can borrow up to 50%. If you decided to spend $4,000 on a certain stock, that would leave you with $6,000 worth of buying power - $1,000 in cash and $5,000 in your margin account (excluding commissions). The money isn't borrowed until the actual cash is gone.

But buying on margin comes with a number of risks. One of these risks comes in the form of a margin call. A margin call usually occurs when the investor's amount of actual capital falls below a certain percent of the total investment. In addition, a margin call can also occur if the broker changes his minimum margin requirement (this is the minimum percentage of the total investment the investor must have in direct equity, usually around 30%).

To better explain a margin call, let's go back the first example. Only this time, you use the entire $10,000-$5,000 of your own equity and $5,000 from the broker, or on margin. After a week, the stock falls and is only worth $7,000, leaving your equity at $2,000. (This amount is figured by subtracting the amount you borrowed from your broker, $5,000, from the stock's current value of $7,000.) Your broker's minimum margin requirement is 30%, or $3,000 in this case. Because you only have $2,000 in equity, you don't meet this minimum margin requirement. Your broker would then issue a margin call.

Once your broker issues a margin call, you have a limited amount of time to replenish the equity. This can be done in a number of ways. You can sell enough of the stock you invested in to cover the minimum requirement, take out a loan from a bank, or you can use your own personal money to bring your equity back up to the minimum margin requirement. Investors typically have three days to replenish their equity once a margin call is issued.

While it may sound bad, a margin call is just part of buying stocks on margin. Because the stock market is so volatile at times, investors can be faced with a margin call overnight, even if they had plenty of equity the night before. Margin calls don't reflect badly on an investor, either. Some investors like to keep their money right at the minimum requirement and get margin calls every time the market dips. How you choose to handle your equity pool, whether you keep your money right at the minimum or far above it determines your chances of getting a margin call.