Do You Understand Margin Calls?
Using margin is not risk free, and it is not something every investor should use. It can accelerate wealth building, but it can also add unnecessary risk. Before deciding whether margin can help you achieve your goals, you first have to define what those goals are and then understand the tools available to help you reach them. I am not saying people should or should not use margin. I am saying fear mongering does not help anyone. It is better to fully understand the risk you are taking so you can make an informed decision instead of an emotional one.
A lot of people hear the words margin call and immediately imagine losing everything. They picture the market dropping, the brokerage liquidating all their investments and the account being completely wiped out. Even here, you read a lot of comments warning that if the market drops, you will get margin called, as if that automatically means you are going to lose everything.Â
Yes, I suppose that can happen, especially when someone is highly leveraged and making a speculative bet on a short term price movement. That is what creates the fear the news headlines, but that is not how every investor uses a margin account, and a normal market downturn does not automatically create a margin call. Even when a margin call does happen, it does not automatically mean you are going to get wiped out.
Let’s say you deposit $500 into an account and borrow another $250 to buy the same fund or another fund with a 30% margin requirement.
This looks very aggressive and it appears you are using 50% margin because you borrowed $250 against your original $500. But after the purchase, you own $750 worth of securities and have a $250 loan. Your actual loan to value ratio is $250 divided by $750, which equals 33.33%.
That is still aggressive, but it is very different from saying that half of the portfolio is borrowed money. The same concept applies to a larger account.
Let’s say you have $100,000 and borrow another $20,000 to invest. You now own $120,000 worth of securities and have a $20,000 loan. Your loan to value ratio is $20,000 divided by $120,000, which equals 16.67%.
So let’s look at what happens when the market moves.
If your $120,000 portfolio increases by 10%, it becomes worth $132,000. You have not made any payments against the loan, so you still owe $20,000, but your loan to value ratio has dropped to 15.15%.
Now let’s go the other way.
Imagine the market falls by 30%. Your $120,000 portfolio is now worth $84,000, but the loan is still $20,000. Your loan to value ratio has increased to 23.81%. That is a significant market decline, but you are still not close to a margin call if the investments continue to have a 30% maintenance requirement.
With a $20,000 loan, the theoretical margin call point would be when the portfolio falls to approximately $28,571. At that point, the $20,000 loan would represent 70% of the account and your remaining equity would represent 30%.
For a portfolio that started at $120,000, that would require a decline of approximately 76%.
And what happens when you get a margin call? Does the brokerage immediately sell all your holdings and leave you with nothing?
Not necessarily. This is where you have to check with your specific broker because every brokerage has its own policies for handling margin calls. Some may give you time to deposit money, transfer in additional securities or sell enough investments to bring the account back above the required maintenance level. Others may begin liquidating positions immediately, especially during fast moving markets, and they are generally not required to wait for you to act.
But receiving a margin call does not automatically mean your entire account is gone.
Let’s say the market falls by 80%. Your original $120,000 portfolio would now be worth $24,000. The margin loan would still be $20,000, leaving you with $4,000 of equity. Your equity would represent only 16.67% of the account, which is below the required 30%.
To restore the account to the 30% maintenance requirement, you would not have to replace the entire market loss or pay off the full $20,000 loan. You would need to deposit approximately $3,200, to bring your equity level back to 30%.
This does not mean an 80% decline would be harmless. Your original $100,000 of personal capital would have fallen to only $4,000 before adding more money, which would be a devastating investment loss. The point is simply that a margin call does not necessarily mean the brokerage sells everything and you walk away with nothing.
The real danger is that the brokerage controls the process. It can raise margin requirements, reduce the lending value of a security or liquidate positions without waiting for your permission. This is why investors should never plan around the absolute margin call threshold and should always maintain a substantial buffer.
Understanding margin maintenance does not make margin risk free, but it does help people understand what the risk actually is instead of assuming that every market decline leads to liquidation and every margin call ends with the account being wiped out.
