A margin call occurs when the investors using a margin account to buy stock and the account balance fall below the minimum requirement. A margin account is a way in which investors buy stock on margin, which means the investor borrows money from a broker to buy stock rather than using their own money. Let say the margin is 50%, it means that you can buy the stock worth $ 2,000 with the balance of only $ 1,000 in your account, the remaining $ 1,000 is borrowed from the broker.
Margin call indicates that the financial instruments in the portfolio have decreased the value over time. The investors have to deposit more money into the account or sell some instruments held in the account.
Margin Call Price Formula
- Initial Purchase Price: The purchase price of the security
- Initial Margin: The minimum percentage which investors must pay to acquire the asset
- Maintenance Margin: The minimum percentage that investors must maintain in marginal accounts.
Margin Call Example
For example, Mr. A opens a marginal account with $ 2,000 in cash and another marginal call of $ 2,000 which is borrowed from the broker. Let say the investor purchase 100 stock at $40 per share, it means he uses all his money and marginal all. Based on the policy, the investor has to maintain a margin of 30%. Please calculate the margin call price for Mr. A.
Margin Call Price = 4,000 * ( 1 – 50%) / (1 – 30%) = $ 2,857
So what does it mean?
It means that the investor must maintain the margin call of 30%, which means that the investor’s fund must be more than 30% of the whole portfolio. If the price of asset fall, and the total amount decrease below the margin call price, the investor must deposit more cash to keep the margin of 30%.
The margin call price is $ 2,857 mean that if we subtract the loan from broker ($2,000), investor fund is only $ 857 which equal to 30% of the whole portfolio ( 30% = $ 857/ $ 2,857). In any circumstance, the stock price decrease, and the total amount are less than $ 2,857, the investor must deposit more cash to keep this ratio.
What if Investors Cannot Pay a Margin Call?
If the investor fails to pay the margin, the broker may force to freeze the account and sell the associate assets. The broker can liquidate the investors’ position when the margin call is not covered. The broker has the right to do so without approval from investors.
Continue from the previous example, if the stock price drop to $ 25 per share, the total portfolio is only $ 2,500 ($ 25* 100 shares). It is below the margin call price, so the investors have two options:
- First deposit more money to increase the total amount up to the marginal price
- Sell some stock at loss to decrease the portfolio and pay back the margin call.
However, if the investors fail to do one of the options above, the broker may liquidate the position and force the sale of the stock the marginal call before the price fall further. In addition, the broker may charge a penalty or fee for the damage during the process.
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