Trading in a margin account allows you to amplify your buying power by borrowing money from your brokerage. In order to trade in a margin account, you are required to deposit a minimum amount, known as the margin requirement. The remainder is the amount you borrow from your brokerage. The brokerage holds the positions in your margin account as collateral for the loan. This leverage can boost your returns, but also comes with certain risks, like margin calls.
Margin calls occur when the value of your account drops below a certain threshold that you need to get it back up to. Here’s what you need to know about what a margin call is, what to do if it happens to you, and how you can avoid it.
What is a margin call?
A margin call is a demand from your broker to fund your margin account. Margin calls occur if you have purchased securities on margin and the value of your account falls below the margin requirement (maintenance margin).
The Canadian Investment Regulatory Organization (CIRO), which regulates investment dealers in Canada, sets the minimum margin requirements for securities. Brokers are allowed to set their own margin requirements, as long as they are higher than the minimums set by CIRO.
What causes a margin call?
Triggering a margin call can occur for a few reasons:
The market value of your securities decreases: If the total value of cash and securities in your account drops below the margin requirement, your account no longer has sufficient collateral to cover the amount borrowed.
The margin requirement increases: Since brokerages can set their own margin requirements, your brokerage may change the margin requirement on a security at any given time. If the margin requirement increases and it causes your account to fall below that threshold, you’ll face a margin call. Brokers may change margin requirements due to factors like volatility, market conditions, credit risk, and more. They’re also not required to notify you of margin rate changes.
You’re shorting a climbing security: If you decide to engage in short-selling and the market value of the security you short increases, your losses could lead to a margin call. Short-selling is a sophisticated and risky trading strategy that involves borrowing and selling a security you believe will drop in price, with the goal of buying it back at a lower price to return to your broker, and pocket the difference.
Interest has been charged to your account: Your brokerage will charge interest on the amount you borrow. If interest is charged to your account and it causes your account to fall below the margin requirement, you will be in a margin call.
What happens during a margin call?
When your account balance drops below the margin requirement, your broker may issue a margin call by phone, email, or through any other form of communication. When an account is in a margin call, it is restricted to closing transactions - i.e, only transactions that decrease the margin call are allowed. Margin calls are payable on demand, and when communicated, usually include a date you must fund the account by. It’s important to note that you’re responsible to ensure that your account doesn’t fall below the margin requirement. Brokers don’t have to notify you when you are in a margin call, so make sure you are familiar with your brokerage’s terms and conditions beforehand.
If you fail to fund your account in time, your brokerage can sell a portion or all of the securities to bring your account above the margin requirement. They don’t have to inform you that they are liquidating your securities, and if they decide it’s necessary, they can sell your securities before the due date or at any other time.
Keep in mind that if you or your brokerage has to liquidate your securities to address a margin call, you might be forced to sell at a loss (or lower profit than intended) with applicable tax consequences.
Example of a margin call
Let’s say you have $1,000 sitting in your account, and you want to use it to buy a security with a 50% margin requirement. This means you can borrow up to $1,000 from the brokerage (represented by a negative cash balance). If you use the combined $2,000 ($1,000 of your own money and $1,000 from the brokerage) to purchase the security, your account balance and margin requirements are as follows:
Cash: -$1,000 (this is the amount you owe the brokerage)
Security: $2,000
Margin requirement: $1,000 (market value of the security x margin rate)
Margin call = $0 (cash + market value - margin requirement)
You can see above, that you are not in a margin call. If, a few days later the price of the security drops by 10%, the value of your account has decreased, and the combined value of cash and securities has fallen below the margin requirement. This means you’re now in a margin call:
Cash: -$1,000
Security: $1,800 (decreased by 10% from original value)
Margin requirement: $900 (market value of the security x margin rate)
Margin call = -$100 (cash + market value - margin requirement)
What to do if you get a margin call
You can respond to the margin call by funding your account to an amount greater or equal to the margin call. Some ways of funding your account back up to the margin requirement include:
Selling securities in the account or;
Transferring in cash or margin-eligible securities.
If you don’t respond to a margin call, or extenuating market conditions exist, the brokerage may liquidate securities in your account to bring your account up to the margin requirement.
If the brokerage has liquidated all the positions in your account and you still owe them money (i.e. your account balance is a debit), your account is considered delinquent and you may be subject to further restrictions.
Ways to avoid a margin call
There are several ways you can lower the risk of a margin call:
Limit your leverage and leave a cushion: You aren’t obligated to use the entire loan amount your broker offers you. Accepting less than the maximum amount gives you a greater equity share in your holdings and a bigger cushion to avoid a margin call. Your funds are always used before the broker’s, and the amount borrowed from the broker is indicated by a negative (debit) cash balance.
Diversify your holdings: Holding a range of different securities may help you withstand market fluctuations and can help you avoid the risk that a decrease in a single security will radically impact the value of your account.
Watch your account: One of the golden rules of investing is not to look at your investments every day — but if you’re using margin, it may be wise to ignore that advice. Some brokerages offer custom alerts which allows you to detect when your account is at risk of a margin call and deposit extra money if required.
