Introduction to Margin Calls
A margin call is a request from your broker asking you to deposit additional money into the margin account you hold with them. This usually happens when the stocks you bought while trading on margin have fallen, forcing you to top up your capital share.
There is a bit to unpack in this paragraph.
First, we’ll start with what it means to trade on margin. It’s when you buy stocks using a combination of your own money and money you borrow, usually from your broker. Borrowed money gives you the extra capital to buy many more stocks than you might otherwise have had, potentially increasing your earnings.
However, margin trading also carries increased risk.
In exchange for lending the extra money, your broker will ask you to put aside enough collateral – in the form of shares – to cover the loan. The stocks you borrow must be from your broker’s Approved Securities List (ASL). Likewise, the money you borrow can only be used to purchase securities from the ASL.
Unfortunately for all of us, stock prices can go down as well as up. If the price of the stocks you used as collateral suddenly drop, your assets might not be worth enough to cover the loan. In this case, your broker would issue a margin call.
This is a request that you repay part of the loan in cash, buy additional shares to increase your collateral, or sell some of the shares you already own (probably at a loss).
This can be an uncomfortable experience for any investor, and one that can end up being very expensive.
So how exactly do you trade on margin?
A better question might be, why would have you?
Well, although margin calls can be difficult to manage, margin trading allows you to significantly increase your potential returns.
This is best illustrated with a simplified example. Let’s say you already own $10,000 worth of Woolworths Group Ltd. (ASX: WOW) shares and you would like to invest an additional $10,000. On the one hand, you could pay the $10,000 cash for the shares up front, out of your own pocket. Alternatively, you can trade on margin and borrow most of the money needed to purchase the additional shares.
Woolworths is listed on your broker’s ASL, and your broker specifies that you can borrow up to 75% of the value of your existing Woolworths holdings, which is called the loan-to-value ratio (LVR) of the security. This means that by depositing only $2,500 of your own money once in a while and borrowing the remaining $7,500 (the maximum LVR), you can always walk away with $10,000 of new Woolworths shares. You can also use your loan to invest in other companies, as long as they are listed on your broker’s ASL.
Now let’s say Woolworths stock price suddenly jumps 10%.
If you had used your own money to buy the new shares, those shares would now be worth $11,000. If you decide to sell them, you could pocket the $1,000 profit (minus transaction fees) and realize your 10% gain. Not a bad thing return on investment.
What if you had decided to trade on margin instead?
In this scenario, you could invest just $2,500 of your own money, then borrow the remaining $7,500 using your existing Woolworths shares as collateral – and end up with the same $10,000 of new Woolworths shares. After Woolworths stock price climbed 10%, these additional holdings would also be worth $11,000. And if you decided to sell your shares, repay the loan, and then pocket your profit, you would have earned the same $1,000 (minus your interest payments and account fees).
However, since you only invested $2,500 of your own money initially, you managed to get a 40% return – your profit of $1,000 divided by your investment of $2,500. This means that by trading on margin, you have managed to quadruple your return on investment!
Can anyone do this?
Margin trading is open to everyone – however, you should ensure you have a full understanding of the risks involved before opening a margin account. Although some brokers allow you to open an account with only small amounts of capital, margin trading is still best suited for investors with a higher risk appetite and enough extra cash to meet any unexpected margin calls.
If you think margin trading might be of interest to you, first make sure it matches your long-term investment goals and personal risk appetite. And reduce your risk by borrowing less than the maximum LVR for the securities – while reducing your upside potential, it also reduces your chances of receiving a margin call.
What are the benefits of margin trading?
As mentioned before, the main advantage of margin trading is that you can significantly increase your returns, which potentially helps you reach your investment goals faster.
And, as margin trading gives you access to increased funding, you can now afford to diversify your investments. Instead of buying shares in just one or two companies, you can invest your borrowed money in four or five companies. Diversification is one of the best ways to reduce your overall portfolio risk because it makes you less dependent on the performance of an ASX stock to grow your wealth.
Additionally, it should be added that the interest paid on an investment loan is generally tax deductible, reducing your overall taxable income.
And the disadvantages?
Unfortunately, margin trading also magnifies your potential losses. A falling market can trigger a series of margin calls, costing investors a lot of money. Just as you top up your account enough to meet the requirements of the first margin call, stock prices could fall again, triggering a second margin call. And this process can go on and on.
Besides the risks, it can also be expensive – so always shop around for the lowest fees. Before subscribing to a margin charge, determine the return you would need to generate from your investments to at least cover your interest payments and account fees, then consider how feasible this is.
What triggers a margin call?
A margin call is triggered when the security value of the assets you have provided as collateral falls below the amount you have borrowed. The “safety value” is the total value of your shares multiplied by their LVR. For example, the starting value of the security value of the $10,000 of Woolworths shares you already owned was $7,500 because the Woolworths shares had an LVR of 75% (according to your broker).
As the market moves, the security value of your Woolworths shares may rise or fall. If it drops below your outstanding loan balance, your broker will issue a margin call.
Brokers can often grant investors an additional buffer on top of the LVR – sometimes 5% of the portfolio value. This means that a margin call will not be triggered until the total security value more the buffer falls below the loan amount.
How to Avoid or Prepare for a Margin Call
Borrow less than the maximum
Just because you box borrow as much as the LVR allows does not mean you to have to. Borrowing less means you’re creating an extra cushion in your margin account. Remember that it is only when the value of the security falls below your outstanding loan balance that a margin call is triggered. The lower the loan amount, the less likely you are to get a margin call.
To diversify
As we have already mentioned, diversification is a great way to reduce the overall risk of your portfolio. This can help you both prepare for (and even avoid) a margin call.
For one thing, if you use a diversified portfolio of ASL stocks as collateral, it becomes less likely to unexpectedly fall below the required minimum collateral amount. And if you use your borrowed money to buy several securities – rather than just one – you are less dependent on a single investment to generate your returns.
If some of your investments have gone up in value while others have gone down, you can take a profit from your best performing stocks and use it to meet any unexpected margin calls.
Set your own “maintenance margin”
Sometimes it is useful to define your maintenance margin. This is a level of capital you maintain in your account that exceeds the minimum security value required by the broker. If you leave extra money in your margin account to act as a buffer, you can avoid any nasty margin calls from your broker.
Regularly monitor your account
The most important thing you can do when trading on margin is to regularly monitor your account. Check the value of your security daily and frequently adjust the amount of leverage you use based on how risky you think the market is. If the conditions are particularly volatileor if prices fall, pay off part of your loan to reduce your leverage or add extra cash to your account as a precaution.
What happens if you can’t pay a margin call?
The worst case scenario is that you receive a margin call from your broker and cannot pay the requested amount. Since margin calls must be satisfied immediately, your broker may force you to sell some of your shares if you don’t have the cash available.
This can mean that you are crystallizing unrealized losses on your investments and missing out on potential future growth opportunities.