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Trading in the financial market may become a daily routine for some individuals. Often, people grow accustomed to stock market investing such as derivatives trading. In several instances, traders opt for margin, make their money book gains, and enjoy returns. However, at times one’s trading account may fall short of the required funds. It is at this point that a margin call comes into play. Let’s decode the meaning of margin call today.
Defining Margin Call
To understand the meaning of margin call, you need to first know the meaning of margin. The margin is a credit provided by a broker to an investor to add money to their margin account. One can open a margin account through a stockbroker to borrow money for purchasing securities. To keep everything in order, the stockholder should always maintain a minimum balance in the margin account. A margin call is activated when your margin account’s balance falls below the broker’s required amount. This threshold amount is often referred to as the maintenance requirement.
How Does a Margin Call Work?
You may now wonder how a margin call works. Let us understand with an example.
- Suppose your broker fixes an initial margin of 35% and a maintenance margin of 10%. You purchase securities worth ₹7,000. Hence, the initial margin is ₹2,450, and the margin debt is ₹3,500. The maintenance margin will be ₹700.
- However, the price of the stock dips to 20%. The value of your portfolio will then be ₹5,600. The maintenance margin will be ₹560.
- In this case, the ratio shall be ₹2,100 {₹5,600 (new portfolio value) minus ₹3,500 (old margin debt)}. As the new maintenance margin is ₹560, the trader must do his best to get at least ₹1,540. (₹2,100- 560).
When the value of securities goes below maintenance margins, we call it a margin call. A broker shall sell the asset to recover his debt if it reaches zero.
Formula for Margin Call Price with Example
Formula to find the margin call goes the following way.
Margin Call Price = Initial Purchase Price X 1- Initial Margin / 1- Maintenance Margin
- An example would be best to comprehend this formula better. Suppose an individual wants to buy a stock for ₹100 with an initial margin of 25%. The margin maintenance of his broker is 10%. This scenario shall unfold in the following manner.
- The trader would buy the stock of ₹100. It would include a contribution of ₹75 from his side and ₹25 from his broker.
- As the broker’s maintenance margin is 10%, the investor has to pay at least 10% of the stock.
- Putting the above data in the formula, we get,
- Margin Call Price = ₹100 X 1- 25% / 1- 10% = ₹83.3
- Fixing the margin call price determines the minimum value the stock should not fall to continue trading. In this example, the margin call price is ₹83.3. So, the broker lent ₹75 and the stock is trading at ₹83.3. The broker’s money is 90.36% of the purchase value. The investor’s money is 9.64 % of the transaction. If the stock price slides below ₹83.3 to ₹77, the broker’s contribution will become 97.4% (₹75/77) Trader’s part is now limited to only 2.6% in the stock. Hence, he would now get the margin call.
Tips to Avoid Margin Calls
Here are some ways to not go through a margin call.
- Maintain enough cash in your trading account
- Rather than putting all your money in financial assets, you can keep some in cash too. This will help you escape margin calls. Cash provides stability even while securities may fluctuate.
- Stay prepared for volatile periods
- Investors should diversify their portfolios and invest in various types of assets. There are many options like stocks, commodities, bonds, derivatives, exchange-traded funds (ETFs) etc., which will be useful during market downturns when volatility is high. If your portfolio withstands the turmoil, your trading account shall not dip below maintenance margins.
- Hold securities which can get you more profits
- Higher returns will keep your trading account afloat with the maintenance margin. With the maintenance margin, higher returns will keep your trading account afloat. You can also go for short-term trades, which may give you quick and high profits. Having enough liquidity in your account will help you repay margin loans and interest.
- Keep paying consistently. This is probably the best approach to avoid margin calls. Interests are applicable every month. As margin loans don’t have a fixed repayment period, traders must pay the dues regularly. This will prevent loan accumulation and limit your outstanding pending loan amount.
- Fix your margin. Traders should develop a habit of fixing their maintenance margins. It should always be above the limit set by the broker. As the account balance reaches below it, traders must add more funds to their trading accounts. As a result, you can avoid unwanted margin calls.
- Trading on margin carries legal consequences if contract terms are breached, potentially leading to asset liquidation in the event of a margin call non-compliance. While margin can amplify returns, it equally heightens the risk of increased losses, potentially exceeding the initial investment. Investors often perceive borrowing from brokers as simpler than from banks, unaware that both involve similar obligations and potential risks.
Conclusion
Gaining a comprehensive understanding of margin calls in options trading is essential for investors navigating the intricacies of the financial markets. The risks and potential consequences associated with margin trading underscore the importance of adhering to contractual terms and being vigilant about margin calls. This knowledge empowers traders to make informed decisions, effectively manage risks, and optimise their trading strategies.