How to Avoid Margin Calls

A margin call results when the value of the collateral an investor puts up to secure a loan from a stockbroker falls below a preset level. The investor may have borrowed money from the stockbroker to buy stock or the investor may have borrowed stock certificates from the broker for the purpose of selling a stock short. In either case, the borrower is required to put up something of real value (money or other stock certificates) to secure the loan. If the value of that security falls, the investor gets a call from the stockbroker asking him or her to put up additional collateral (margin) to secure the loan.

What Causes Margin Calls

The rules that govern how a broker treats its clients (and which allow the broker to sell the investors shares without notice) are documented in the margin agreement made between the investor and the stockbroker. Margin agreements are written by the stockbroker for the benefit of the stockbroker. It is vital that ordinary margin investors read that agreement and understand exactly what it means.

Investors are typically required to put up initial collateral worth at least 50 percent of a total investment. For example, to buy $100 worth of stock the investor would have to put up $50 worth of collateral. Once invested, the margin will decrease if the value of the investor’s investment falls.

But the margin can only decrease so far before the stockbroker will ask for additional collateral. Typically, when the value of the investment falls to 25 to 40 percent of the value of the loan, the investor will receive a margin call requiring that they put up additional collateral. If the investor doesn’t have additional collateral to put up, the stockbroker will close the investor’s position at a loss.

Margin Calls for Short Sales

A margin call for a short sale works essentially the same way as a margin call for a long investment in stocks. The investor puts up 50 percent of the value of the short sale as security and the broker keeps control of the money the investor received for selling the stock they borrowed from the broker.

If the stock price goes up, the broker asks the investor to put up more money as collateral. If the investor has no money to put up, the broker takes the investor’s money and buys the stock back on the open market. The stockbroker typically does not look for the best price for the stock.

Avoiding Margin Calls

The easiest way to avoid a margin call is not to borrow from a stockbroker.

Buying stock on margin and short selling are sophisticated investment techniques that can make sophisticated investors money. If an investor can make a better return on an investment than the interest rate the stockbroker charges, then the investor would want to take advantage of the additional leverage that margin investing provides them.

The leverage provided by margin investing is especially true for short selling where a stockbroker can lend investors stock at very low interest rates since the broker isn’t paying the owners of the stock anything to hold onto the certificates for them.

For someone interested in using leverage to make outsized investment gains, one way to avoid margin calls is to make wise investment decisions.

Do not fall in love with a stock –the mark of a true investment professional is the ability to accept that you’ve made a bad decision and cut your losses.

On the other hand, Warren Buffett believes that if the market is offering a 50 percent discount on a stock you thought was a great buy at twice the price, unless something has happened to the company, you really ought to load up on the stock.

Putting “stop-loss” orders on your investments is a good way to avoid getting overly-emotional about the market having a different opinion on the value of your stock than you have.

Don’t bet against the tape (if the market is going in a particular direction, don’t bet against it).

Don’t bet against the Federal Reserve (if the Federal Reserve wants stock prices to go up, chances are, they will go up.)

No matter how wonderful a company is, bad management can damage the company’s competitive advantage and cause financial loss, however, it is nearly impossible for even full-time investors to judge the quality of a company’s management except in retrospect.

Remember that the stock market is a popularity poll in the short term and a yard stick in the long term – short term gains are based on people’s opinions of what long term earnings will be and long term gains are based on what those long term earnings actually are.

The final rule of thumb to remember is that it is unwise to bet more money than you can afford to lose.

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