Margin accounts are a type of brokerage account that allow investors to trade on margins. These accounts come with several features, allowing investors to benefit from them. However, there are some risks that investors must bear with these accounts as well. One such risk is that of a margin call. Therefore, investors must understand what it is and how it affects them.
What is a Margin Call?
A margin call occurs when the equity in an investor's margin account falls below a broker's minimum requirements. Usually, this requirement comes in the form of a maintenance margin that brokerage firms set for their margin accounts. Through a margin call, brokerage firms demand investors to top up the margin account's balance to the maintenance margin requirement.
Investors need to comply with the demand from the broker. In case they don't, they can risk losing the securities within their margin accounts. When investors receive a margin call, they must either deposit funds or unmargined securities into their accounts. Alternatively, they can also sell their current securities to free up some margin in their account.
A margin call also indicates that a single or some securities within a margin account have decreased in value. Due to the drop in value, the account will have fallen below the maintenance margin. Therefore, brokerage firms will use a margin call to demand more equity for their security.
How to calculate the Margin Call Price?
Investors can calculate the margin call price themselves for their margin accounts. It is the value at which they will receive a margin call from the brokerage firm. The formula to calculate the margin call price is as below.
Margin Call Price = Initial Purchase Price x (1 - Initial Margin) / (1 - Maintenance Margin)
In the above formula, the initial purchase price is the amount initially paid for the security by the investor. The initial margin is the minimum percentage of the security's value that investors must pay for the purchase. Lastly, the maintenance margin is the minimum percentage of equity that investors must maintain in their accounts.
Example
An investor purchases a security for $60. The initial margin set by the brokerage firm is 50% of the security’s value. Similarly, the maintenance margin for the margin account is 25%. Therefore, the margin call price for the investor will be as follows.
Margin Call Price = Initial Purchase Price x (1 - Initial Margin) / (1 - Maintenance Margin)
Margin Call Price = $60 x (1 - 50%) / (1 - 25%)
Margin Call Price = $40
It means that if at any time, the investor’s margin account balance falls below $40, they will receive a margin call from the broker.
What happens if investors fail to meet a Margin Call?
When investors fail to satisfy a margin call, they can have any open securities within their margin account closed. It allows the brokerage firm to reinstate the account back to the minimum value. The brokerage firm does not require the investor’s approval to do so. Brokerage firms may increase their commissions and interest rates on the loaned amount as well.
Conclusion
Margin calls are when the equity balance in an investor's margin account falls below the maintenance margin. Margin calls are crucial for investors as they indicate a security within their account has decreased in value. If investors fail to meet margin calls, they can have their open securities closed to restore the minimum balance.
Article Source Here: What is a Margin Call
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