You might have come across the term 'margin call' and wondered what it actually means. Whether you’re a seasoned investor or just starting out, understanding margin calls can help you manage risk.

Margin calls aren’t something most long-term investors deal with daily, but if you’re borrowing to invest , they can have a big impact. This article will explain what a margin call is, how it works, and how it could affect your investments.

Hopefully, it’ll give you a clearer understanding of margin calls and prepare you to make informed choices about your investing strategy.

What is a margin call?

Some investors borrow money from a brokerage firm to increase their investment power. This is known as margin trading. While margin trading can boost potential returns, it also increases risk. If the value of your investments drops below a certain level, your broker may issue a margin call. A margin call is when your broker asks you to add more money or assets to your account to cover losses. If you don’t add funds, your broker may sell some of your assets to make up the difference.

Unlike some other types of financial calls or orders, a margin call isn’t a suggestion – it’s a demand. For example, a buy order is when you instruct your broker to purchase an asset at a certain price. In contrast, a margin call is about maintaining enough money in your account to cover your investment losses. Each type of call or order serves a different purpose, so understanding them helps you handle your investments more effectively.

Margin calls can affect exchange-traded funds (ETFs ) similarly to individual shares if you're using margin to trade. Both types of investments can lose value, triggering a margin call.

However, ETFs typically hold a basket of assets, which might spread the risk compared to holding individual shares. This diversification may potentially reduce volatility, but it doesn't eliminate the chance of a margin call if the market declines significantly.

Knowing how margin calls work is important, especially if you’re using borrowed money to invest.

How is a margin call triggered?

As mentioned above, a margin call occurs when the value of your investments, which act as collateral for the loan, falls below the minimum required. This minimum, called the maintenance margin, ensures that your broker has enough collateral to cover the borrowed funds. When your investments drop in value and no longer meet the maintenance margin requirements, your broker issues a margin call.

Collateral is key because it’s what secures the loan. If your collateral – your investments – loses value, you’ll need to deposit more funds or assets into your account to meet the maintenance margin. Failing to do so could result in your broker selling your investments to make up the difference.

Market changes can quickly affect asset values, making margin calls possible.

What are the consequences of a margin call?

When a margin call happens, you must act quickly to avoid losing control of your investments. You’ll need to deposit additional funds or assets into your account to bring it back to the required level.

Here are some of the potential risks:

• Forced selling of assets : If you don’t meet the margin call, your broker can sell your investments to cover the shortfall. This often happens without your consent, meaning you lose control over which assets are sold.
• Locking in losses : When assets are sold to cover a margin call, you might be forced to sell at a loss. If the market recovers later, you’ll potentially miss out on the potential gains.
• Amplified losses : Since margin trading involves borrowed money, losses can multiply quickly. If your investments decline, you’ll owe more than your original investment, increasing your financial exposure.
• Debt accumulation : If your portfolio continues to decline, you might owe more money to your broker than you originally borrowed. This can leave you in debt beyond the value of your initial investment.
• Loss of control over investment strategy : Meeting a margin call may require selling other assets you didn’t plan to sell, disrupting your long-term strategy and potentially affecting your financial goals.

Understanding the potential consequences of margin calls is important when deciding whether to trade on margin.

How can margin calls impact investor portfolios?

Real-word examples

Margin calls have dramatically impacted investors during key market events, revealing the risks of trading on borrowed funds. A notable example is the 2008 financial crisis. As the housing market collapsed, many investors saw their portfolios lose value rapidly. Those who had used margin faced margin calls they couldn’t meet, resulting in forced sales at large losses. The widespread selling amplified the market’s decline and worsened the crisis.

Another example is the 2021 GameStop short squeeze. Many investors who had borrowed money to short sell GameStop (a US video game retailer) shares were caught off-guard when the stock’s price surged unexpectedly. Unable to meet margin calls, they were forced to close their positions, often taking significant losses in a short time. This event shows how quickly market conditions can change, especially during extreme market volatility.

These examples highlight how margin calls can increase losses when the market moves against you. However, it’s important to remember that past market events don’t guarantee future outcomes, and performance can change with new conditions.

Hypothetical scenario

Margin calls don’t always lead to negative outcomes. In some cases, they can protect investors from even greater losses. For example, imagine an investor uses margin to buy shares in a company, expecting the stock price to rise. However, the market starts to decline. The broker issues a margin call, forcing the investor to sell some shares. While this results in a loss, it limits the investor’s exposure to further declines. In this scenario, the margin call serves as a safeguard, preventing a much larger financial setback.

However, it’s important to note that this example is hypothetical, and past or current market conditions don’t predict future outcomes. Margin calls can affect investors differently depending on market changes and investment strategies.

How can investors manage margin call risks?

Managing the risks of margin calls requires a thoughtful approach to protecting your investments.

Here are a few practical strategies to help you stay prepared.

• Maintain a buffer : Keeping extra funds or assets in your account above the required margin reduces the chance of triggering a margin call during market dips.
• Use stop-loss orders : Setting stop-loss orders automatically sells your assets if they fall to a certain price, helping to limit potential losses before they escalate.
• Monitor your investments regularly : Keeping a close eye on your portfolio, especially during market volatility, can allow you to respond quickly and avoid being caught off guard by a margin call.
• Know your risk tolerance : Understand how much risk you’re comfortable with. If you prefer a more conservative approach, you might want to avoid borrowing too much to invest.

While margin calls can amplify gains, they also increase losses. Actively managing your risks and being aware of market conditions can help you better navigate the challenges of trading on margin.

What are the regulations and rules on margin calls?

Understanding margin call regulations and broker policies is important before trading on margin. Different markets have specific rules that govern margin trading, including the minimum margin requirement and how brokers handle margin calls. These rules help protect both brokers and investors, ensuring that accounts maintain enough collateral.

Australian regulations

In the Australian market, margin trading is regulated by the Australian Securities and Investments Commission (ASIC) . ASIC requires brokers to maintain specific minimum margin levels, which act as a buffer to protect both the broker and the investor. Brokers may set higher minimums than required by ASIC, so it’s important to understand your broker’s margin requirement.

Broker margin call policies

While ASIC regulates margin trading, each brokerage firm has specific policies on how and when margin calls are issued. Some brokers may give more time to meet a margin call, while others may act faster to sell off assets. It's crucial to review your broker’s terms so you know the margin requirement and what to expect if a margin call occurs.

Understanding both market rules and broker policies can help you manage risks and avoid surprises. Always make sure you’re familiar with the regulations and broker terms before using margin in your investing strategy.

Other things to consider about margin calls

For long-term investors, managing margin calls takes some extra thought, and pose further challenges. Here are a few key things to keep in mind.

Interest charges can add up

When you trade on margin, you're essentially borrowing money (margin borrowing), and that comes with interest. Over time, these charges can quietly eat into your overall returns. It’s important to factor interest into your strategy, especially if you plan to hold investments for a long period.

Volatility can catch you off guard

Markets can be unpredictable, and sudden drops can trigger margin calls faster than expected. Even temporary daily price swings can force you to make tough decisions. Staying on top of market movements and maintaining a buffer can help reduce the stress of unexpected margin calls.

The emotional toll

Margin calls can be stressful. Being forced to sell assets at a loss can disrupt your long-term strategy and cause emotional strain. It’s essential to remain calm, assess your situation, and make decisions based on your long-term goals rather than short-term emotions.

Tax implications are real

Selling investments to meet a margin call may trigger taxes, particularly capital gains tax . Depending on your tax situation, this could reduce any potential profits or add to your losses. It’s worth considering the tax impact before making any forced sales.

Is margin trading right for your strategy?

Not all strategies work well with margin trading. Long-term investors with a conservative approach might find margin trading exposes you to unnecessary market risk. Take time to evaluate if margin trading fits within your goals, risk tolerance, and overall strategy.

Whether or not you use margin calls when investing is up to you. The goal is to make educated decisions that align with your investing approach and help you achieve your objectives.

Here’s what to remember about margin calls

As you may have surmised, margin trading doesn't really gel with Pearler's investing ethos. Margin calls are a key part of margin trading, and can have a big impact on your investments. They may bring the chance for growth but also carry added risks, especially when markets get volatile.

The main takeaway? Keep yourself informed before ever considering margin trading. And, while we often suggest this, you should definitely speak with a financial adviser before attempting it. By understanding the risks, you can feel more confident about handling margin calls. Most importantly, keep your decisions aligned with your long-term goals to stay on track.

Happy investing!