Understanding Margin Calls and How to Avoid Them
Trading on margin allows investors to take advantage of opportunities in the stock market by borrowing money from their broker. While this enables larger investments, it also comes with the risk of a margin call. Understanding what a margin call is and how to avoid it is crucial for successful margin trading.
What is a Margin Call?
A margin call occurs when the value of your margin account drops below the maintenance margin set by your broker. Margin accounts allow you to purchase securities using both your funds and borrowed money, increasing your buying power. However, the Financial Industry Regulatory Authority (FINRA) requires that you maintain at least 25% of the account’s value with your own funds, known as the maintenance margin. If your account value falls below this level, your broker will issue a margin call, requiring you to either deposit more funds or sell securities to meet the requirement.
Example of a Margin Call
For instance, if you invest ₹10,000 of your own money and borrow ₹10,000 from your broker, your total investment is ₹20,000. If the market value of your investment drops to ₹11,000, you must maintain at least ₹2,750 (25%) in your account. If your account value falls short, a margin call will be issued, requiring you to deposit additional funds or sell assets to cover the difference.
How to Avoid a Margin Call
To prevent a margin call, follow these strategies:
- Keep extra cash in your account: This offers a buffer in case the market declines, preventing your account from dropping below the maintenance margin.
- Diversify your portfolio: Reducing reliance on a single type of security can lower volatility and reduce the risk of falling below the margin requirement.
- Monitor your account regularly: Regularly checking your margin account helps you act quickly if you’re nearing a margin call.
- Set a higher personal limit: By setting your own margin limit above the required 25%, you give yourself extra time to deposit funds before a margin call is triggered.
By understanding margin calls and implementing these precautions, you can manage the risks of margin trading effectively.