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Investing in the stock market can provide some of the highest returns on an initial investment. But it’s not without risk.
One of those risks is a margin call.
What is a margin call, and more importantly, how can you avoid it?
In this article, we’ll break down what a margin call is so that you, whether you’re a new or experienced investor, can avoid it and keep your investments profitable.
What is a Margin Call?
To fully understand a margin call, let’s examine what a margin is first.
Margin is a loan given to investors by a brokerage, using the stocks held in their account as collateral. Once your margin account is set up and funded, you may begin trading stocks, bonds, and more.
Most brokers require you to have a minimum of $2,000 in your brokerage account before they will let you trade on margin.
Now, a margin call.
A margin call occurs when the stocks you hold fall below the maintenance requirement — what’s known as a maintenance margin — set by your brokerage.
Margin calls are usually triggered during incidences of extreme market volatility where brokers try to reduce their risk by calling in margin loans — with little notice.
In the case of a margin call, you will have to add additional money and or sell your securities to bring your account back up to the minimum value.
If you don’t — for example, if you don’t access your account and you aren’t aware of a margin call in the first place — the broker can close out your open positions, resulting in steep losses and expensive tax implications.
Margin Call Example
Let’s say an investor buys $30,000 worth of Tesla stock using $15,000 of cash sitting in their brokerage account, and $15,000 of margin offered to them by their broker.
We’ll also assume that these shares cost him $750 each.
At this point, the investor has 50% equity in his Tesla position. Equity is calculated:
Investor Equity = Market Value of Portfolio - Money Borrowed / Market Value of Portfolio
Your maintenance margin will vary depending on your broker, but for simplicity’s sake, let’s say this investor’s maintenance margin is 25%.
If Tesla stock falls to $450, the investor’s equity is only 17%. The investor will then experience a margin call and can either:
- Deposit additional cash and/or securities into the account
- Sell securities
- If neither of these are done, the broker will begin closing out positions
5 Ways to Avoid Margin Calls
Next, we’ll look at 5 specific ways you can avoid a margin call.
Option #1: Leave Extra Cash in Your Account as a Cushion
Holding extra cash in your account will help mitigate the effects of extreme volatility in the market.
Option #2: Monitor Your Account Daily
A simple option to avoid a margin call is to monitor your account daily, because if you aren’t monitoring it and the market experiences a sudden downturn, it can result in a margin call.
Option #3: Monitor the Economic Landscape
If you are monitoring the economic landscape and begin to see volatility, you can make quick yet methodical decisions to protect your position(s) and avoid a margin call.
Option #4: Set a Personal Trigger Point
A personal trigger point, such as a trailing stop loss, will help mitigate your risk for a margin call.
A trailing stop loss will sell off your assets if they drop below a certain predetermined value, which can be helpful when it comes to preserving the value of your portfolio.
Option #5: Make Wise Investments That Will Return High ROI
One of the best options to avoid a margin call is simple, yet can be challenging: make wise investing decisions.
Stocks with high volatility can be appealing, but in the case of volatility and a resulting margin call, dangerous.
By investing wisely and for the long term, you can avoid losses that a margin call creates.
The Bottom Line: Avoid Margin Calls
Margin calls are one of the ways that your investing profit can be reduced — or even lost.
Mitigate your risk with any one of these 5 strategies, and above all, commit to growing your stock investing knowledge with resources like this so that your next investment decision will be your safest and most profitable one yet.