Leverage using Calls, Not Margin Calls

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Leverage using Calls, Not Margin Calls

To achieve higher returns in the stock market, besides doing more homework on the companies you wish to buy, it is often necessary to take on higher risk. A most common way to do that is to buy stocks on margin.

Buying on margin lets the investor use stocks as collateral to borrow money to buy more stock. Currently, investors can borrow up to half the value of the stock they wish to purchase. Your broker gladly loans you as much money as you put up, and charges you a very attractive interest rate. If the stock goes up by $1, you gain $2 since you have now have twice the number of shares. Higher risk, higher profit.

Suppose you have $10000 and wish to buy some shares of XYZ stock currently trading at $50. That amount will only allow you to buy 200 shares. Buying on margin lets you borrow another $10000 so you can buy a total of 400 shares. The total investment is $20000.

Buying on margin, however, is like a sword that cuts both ways. While its nice to know that you are earning $2 every time the share price goes up by $1, the converse is true. Every time the stock drops by a dollar, you also lose $2. Worse yet, if the stock price comes crashing down, you get the dreaded margin call and may be forced to sell the stock at the very time when you would rather be buying it instead.

Alternatively, with call options, you pay a premium for a right to purchase the underlying stock at a predetermined price (strike price) for a period of time – up to 2 years with LEAPS® options. In simpler terms, buying call options is like renting the underlying stock. Each call option represents 100 shares.

Following the same example above, suppose a 3 month call option on XYZ stock with strike price of $50 is available for $3 each. To control the same amount of XYZ stock, which is 400 shares, requires the purchase of 4 call options for a total investment of only $1200. This is also the maximum amount you can lose if you are wrong about the stock. Comparatively, leveraging using margin requires a hefty $20000 and worse still, you risk a margin call!

Hence, buying on margin is a dangerous way to gain leverage, especially when the underlying stock is very volatile. A better option will be to buy call options instead. In options trading, the purchase of call options is better known as a call buying or long call strategy

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Leverage using Calls, Not Margin Calls

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Margin Call

What Is a Margin Call?

A margin call occurs when the value of an investor’s margin account (that is, one that contains securities bought with borrowed money) falls below the broker’s required amount. A margin call is the broker’s demand that an investor deposit additional money or securities so that the account is brought up to the minimum value, known as the maintenance margin.

A margin call usually means that one or more of the securities held in the margin account has decreased in value below a certain point. The investor must either deposit more money in the account or sell some of the assets held in the account.

Key Takeaways

  • A margin call occurs when a margin account runs low on funds because of a losing trade.
  • Margin calls are demands for additional capital or securities to bring a margin account up to the minimum maintenance margin.
  • Brokers may force traders to sell assets, regardless of the market price, to meet the margin call if the trader doesn’t deposit funds.

Margin Call

How Margin Calls Work

A margin call arises when an investor borrows money from a broker to make investments. When an investor uses margin to buy or sell securities, he pays for them using a combination of his own funds and borrowed money from a broker. An investor’s equity in the investment is equal to the market value of securities minus borrowed funds from the broker. If a margin call is not met, the broker may be forced to liquidate securities in the account at the market.

A margin call is triggered when the investor’s equity, as a percentage of the total market value of securities, falls below a certain percentage requirement, which is called the maintenance margin. The New York Stock Exchange (NYSE) and FINRA require investors to keep at least 25% of the total value of their securities as margin. Many brokerage firms may require a higher maintenance requirement—as much as 30% to 40%.

Obviously, the figures and prices with margin calls depend on the percent of the margin maintenance and the equities involved. But in individual instances, the exact stock price below which a margin call will be triggered can be calculated. Basically, it will occur when the account value, or account equity, equals the maintenance margin requirement (MMR). The formula would be expressed as:

Let’s say you open a margin account with $5,000 of your own money and $5,000 borrowed from your brokerage firm as a margin loan. You purchase 200 shares of a marginable stock at a price of $50 (under the Federal Reserve Board’s Regulation T, you can borrow up to 50% of the purchase price). Assume that your broker’s maintenance margin requirement is 30%.

Your account has $10,000 worth of stock in it. In this example, a margin call will be triggered when the account value falls below $7,142.86 (i.e. margin loan of $5,000 / (1 – 0.30), which equates to a stock price of $35.71 per share.

What Happens After a Margin Call

Using the example above, let’s say the price of your stock falls from $50 to $35. Your account’s now worth $7,000, and it triggers a margin call of $100.

You have one of three choices to rectify your margin deficiency of $100:

  1. Deposit $100 cash in your margin account, or
  2. Deposit marginable securities worth $142.86 in your margin account, which will bring your account value back up to $7,142.86, or
  3. Liquidate stock worth $333.33, using the proceeds to reduce the margin loan; at the current market price of $35, this works out to 9.52 shares, rounded off to 10 shares.

If a margin call is not met, a broker may close out any open positions to bring the account back up to the minimum value without your approval. That means the broker has the right to sell any stock holdings, in the requisite amounts, without letting you know. Furthermore, the broker may also charge you a commission on these transaction(s). You are responsible for any losses sustained during this process.

The best way to avoid margin calls is to use protective stop orders to limit losses from any equity positions, as well as keep adequate cash and securities in the account.

Real World Example of a Margin Call

An investor buys $100,000 of Apple Inc. using $50,000 of his own funds and borrowing the remaining $50,000 from the broker. The investor’s broker has a maintenance margin of 25%. At the time of purchase, the investor’s equity as a percentage is 50%. Investor’s equity is calculated as: Investor’s Equity As Percentage = (Market Value of Securities – Borrowed Funds) / Market Value of Securities. So, in our example: ($100,000 – $50,000) / ($100,000) = 50%.

This is above the 25% maintenance margin. So far, so good. But suppose, two weeks later, the value of the purchased securities falls to $60,000. This results in the investor’s equity tumbling to $10,000 (the market value of $60,000 minus the borrowed funds of $50,000), or 16.67% ($60,000 – $50,000) / ($60,000)

This is now below the maintenance margin of 25%. The broker makes a margin call, requiring the investor to deposit at least $5,000 to meet the maintenance margin.

Why $5,000? Well, the amount required to meet the maintenance margin is calculated as:

Amount to Meet Minimum Maintenance Margin = (Market Value of Securities x Maintenance Margin) – Investor’s Equity

So, the investor needs at least $15,000 of equity (the market value of securities of $60,000 times the 25% maintenance margin) in his account to be eligible for margin. But he only has $10,000 in investor’s equity, resulting in a $5,000 deficiency ($60,000 x 25%) – $10,000.

What Happens If I Cannot Pay a Margin Call?

A margin account lets investors borrow funds from their broker in order to augment the buying power in their account, using leverage. This means that with 50% margin, you can buy $1,000 worth of stocks with just $500 cash in the account – the other $500 being loaned by your broker.

Key Takeaways

  • A margin account allows investors to borrow funds from their broker in order to leverage larger positions with the cash they have available, boosting their buying power.
  • A margin call occurs when the value of the account falls below a certain threshold, forcing the investor to add more money in order to satisfy the loan terms from the broker or regulators.
  • If a margin call is issued and the investor is unable to bring their investment up to the minimum requirements, the broker has the right to sell off the positions and also charge any commissions, fees, and interest to the account holder.

Minimum Margin

Minimum margin is the amount of funds that must be deposited with a broker by a margin account customer. With a margin account, you are able to borrow money from your broker to purchase stocks or other trading instruments. Once a margin account has been approved and funded, you are able to borrow up to a certain percentage of the purchase price of the transaction. Because of the leverage offered by trading with borrowed funds, you can enter larger positions than you would normally be able to with cash; therefore, trading on margin can magnify both wins and losses. However, just as with any loan, you must repay the money lent to you by your brokerage.

The minimum margin requirements are typically set by the exchanges that offer various shares and contracts. The requirements change in response to factors such as changing volatility, geopolitical events, and shifts in supply and demand. The initial margin is the money that you must pay from your own money (i.e., not the borrowed amount) in order to enter a position. Maintenance margin is the minimum value that must be maintained in a margin account. The maintenance margin is usually set at a minimum of 25% the value of the securities held.

Note that federal regulations, known as Reg. T, require that for initial margin purchases, a maximum of 50% of the value of securities held must be backed by cash in the account.

Margin Calls

A margin call occurs if your account falls below the maintenance margin amount. A margin call is a demand from your brokerage for you to add money to your account or closeout positions to bring your account back to the required level. As an example, assume the $1,000 of shares purchased above loses 3/4 of its value, so it is now worth just $250. The cash in your account has fallen to 3/4 of its original amount, so it has gone from $500 to $125. But you still owe $500 to your broker! You will need to add money to your account to cover that since your shares are not worth nearly enough at this point to make up the loan amount.

A margin call is thus triggered when the investor’s equity, as a percentage of the total market value of securities, falls below a certain percentage requirement, which is called the maintenance margin. The New York Stock Exchange (NYSE) and FINRA, for instance, require investors to keep at least 25% of the total value of their securities as margin. Many brokerage firms may require an even higher maintenance requirement—as much as 30% to 40%.

The best way to avoid margin calls is to use protective stop orders to limit losses from any equity positions, as well as keep adequate cash and securities in the account.

Failure to Meet a Margin Call

The margin call requires you to add new funds to your margin account. If you do not meet the margin call, your brokerage firm can close out any open positions in order to bring the account back up to the minimum value. This is known as a forced sale or liquidation. Your brokerage firm can do this without your approval and can choose which position(s) to liquidate. In addition, your brokerage firm can charge you a commission for the transaction(s), and any interest due on the money loaned to you in the first place. You are responsible for any losses sustained during this process, and your brokerage firm may liquidate enough shares or contracts to exceed the initial margin requirement.

Forced liquidations generally occur after warnings have been issued by the broker, regarding the under-margin status of an account. Should the account holder choose not to meet the margin requirements, the broker has the right to sell off the current positions.

The following two examples serve as illustrations of forced selling within a margin account:

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