Your First Margin Call

As markets grew volatile this year, you may have found yourself fielding a request from your brokerage to top up your margin account. As if falling stock prices weren't bad enough, suddenly you're being asked to either pour more money or securities into your account or sell stock to bring your account back up to the minimum maintenance level. What's the smartest way to proceed?

The first thing to acknowledge is that margin calls come with the territory. If you're going to trade with borrowed money in the hope of boosting your profits, you also have to accept the possibility that an investment won't work out and you'll have to cover a margin call.

Here we'll review how margin calls work, some options for responding to them, and tips for how to approach future trades so you can better manage your risk.

When you buy stocks on margin or have a margin loan, you must maintain a certain percentage of "equity" in your account—known as the margin requirement—to serve as collateral. This just means you will always have to have some skin in the game, whether in the form of cash or securities you've deposited in the account.

The size of the margin requirement varies by security. For many marginable stocks, it's 30% of the value of your position, but you could also see requirements of 75% or even 100%. Generally, the higher the requirement, the less valuable it is for collateral purposes, as we'll see below. (Some securities, such as penny stocks or IPO shares, are considered nonmarginable, and so won't affect your calculations.)

If your margin account holds multiple securities with different margin requirements, as is common, your account's overall margin requirement will be equal to sum of your various securities' individual requirements.

The wrinkle with margin, of course, is that while the value of your collateral fluctuates with the market, the amount you borrowed stays the same, assuming you don't close out the account and repay your loan. If the value of the stocks you're using as collateral falls, so does the ratio of your equity relative to your margin debt. (Sometimes your securities don't even have to fall to hurt your equity in the account. If your brokerage decides to change a security's margin requirement, you could come up short regardless of what the market's doing.)

If your equity ratio falls below the minimum, your brokerage will issue a margin call, and you will be required to bring your equity back up to the required level.

You have a few ways to respond to a margin call. But not all responses are the same in terms of the credit you gain against the call—some give you much more bang for your buck than others. This matters because you don't want to transfer—or dump—what seems like a lot of stock to boost your equity, only to discover that you still haven't met the call. In fact, it often makes sense to do more than the minimum as further declines in the market could lead to additional margin calls.

Before we get into the responses, though, we'll need an example portfolio:

Assume you've got $5,000 of cash and buy $5,000 stocks on margin. Your portfolio holds:

• $5,000 of Stock XYZ, which has a 30% margin requirement ($5,000*0.3=$1,500)
• $3,000 of Stock ABC, which has a 75% margin requirement ($3,000*0.75=$2,250)
• $2,000 of Stock XXX, which is nonmarginable. (That means no margin requirement, but XXX doesn't count toward your equity.)

That gives you an overall position amounting to $10,000, including $2,000 of nonmarginable stock. The $5,000 of cash you put in to open the position is your equity, and the margin requirement for your $8,000 of marginable stock comes to $3,750 ($1,500+$2,250). So far, so good.

Then volatility strikes, leaving all three of your stocks down from where you bought them. Now you hold:

• $4,500 of Stock XYZ, which has a 30% margin requirement ($4,500*0.3=$1,350)
• $1,500 of Stock ABC, which has a 75% margin requirement ($1,500*0.75=$1,125)
• $1,000 of Stock XXX, which is nonmarginable.

That means you now have marginable stock worth $6,000 ($4,500+$1,500), with a margin requirement of $2,475 ($1,350+$1,125). However, your $5,000 of margin debt hasn't changed, so instead of $5,000 of equity, you now have just $1,000 ($6,000-$5,000)—$1,475 short of the margin requirement.

What's the most efficient way to get to $1,475? In order of desirability, here are some options:

Deposit cash. Every dollar in cash you place in your margin account counts as $1 of equity. Notice, however, that injecting cash doesn't increase the value of your account or lower the margin balance.

Amount: $1,475

Sell nonmarginable securities. Selling your nonmarginable securities (like Stock XXX) will also free up cash on a dollar-for-dollar basis. However, in our example, we don't have enough Stock XXX to cover the full margin call. That means we'll have to make up the difference with cash.

Amount: $1,000 + $475 of cash

Deposit marginable securities. Transferring more marginable securities to your margin account will effectively boost the total value of your position—and your equity—relative to the size of your margin debt. But be aware that the value of your deposit will end up being larger than your margin call because it will effectively be discounted by the securities' maintenance requirement—so, the lower the maintenance requirement the better. (Why? Lower margin requirement securities boost your buying power with a smaller commitment of collateral than higher margin requirement securities.)

Here is the equation you will use: amount of margin call / (1 - maintenance requirement %).

For example, if you deposit more Stock XYZ, which has a 30% maintenance requirement:

Amount: $1,475 / (1 – 0.3) = $2,107.14

As you can see, depositing securities increases your equity and the total value of your margin portfolio. Your portfolio is now worth $9,107.14, of which $3,107.14 is your equity. But there's a kicker: Your account's margin requirement is also now $3,107.14.

What if you decided to deposit more of Stock ABC, with its 75% maintenance requirement instead? Your deposit would have to be more than three times larger:

Amount: $1,475 / 1 – 0.75 = $5,900

Sell marginable securities. Rather than boosting the size of your position relative to your debt, you could shrink your debt by selling marginable securities. Again, the amount you sell will have to be larger than the size of your margin call because of the maintenance requirement discount—but this time, the higher the maintenance requirement the better. (Why? Because you're required to carry a bigger stake in such securities, you get more credit when you sell them.)

Here is the equation: amount of margin call / maintenance requirement of security being liquidated.

For example, if you sell Stock ABC, which has a 75% maintenance requirement:

Amount: $1,475 / 0.75 = $1,966.67

Because we have only $1,500 of Stock ABC, we'll have to make up the difference with $466.67 of cash.

As you can see, selling marginable securities decreases your debt, while the cash injection boosts your equity. Your portfolio is now worth $5,550, of which $1,466.67 is your equity stake.

What if you decided to sell Stock XYZ, with its 30% maintenance requirement instead? You would have to sell more than twice as much stock and still deposit cash:

Amount: $1,475 / 0.3 = $4,916.67

Plus $416.67 cash
 

If receiving and meeting a margin call proved to be too harrowing for your taste, here some ideas to consider for managing your risk in the future.

• Clip your wings. Borrow less than the maximum amount allowable in your account. You can also maintain an equity level for yourself that is higher than your brokerage's requirements—say, 50% when your brokerage is asking for 30%—and monitor your portfolio to ensure you don't go below that level.
• Diversify your portfolio. This can help lower the risk that a single security's drop in value will trigger a margin call.
• Watch more closely. Be aware of what is going on in the market. Recognize that margin comes with increased risk, and consistently reassess your risk tolerance. Anticipate a potential decline in value, especially during uncertain or volatile market conditions.
• Have a plan. Develop a risk-management strategy for your investments that is consistent with your market outlook and stick to it. At the same time, have contingency plans for dealing with potential margin calls, including a repayment plan just in case the market turns.

Finally, it's worth noting that even if you haven't received a margin call, it's probably best to use margin infrequently and for a limited amount of time. Margin can help boost your gains on winning trades, but because you must pay interest, you should think of it as expense, albeit one that is tax-deductible if you itemize and use the funds to purchase securities.