Avoiding The Margin Call

However, there is another side to trading on margin. There are occasions when your brokerage can sell off your stocks without your permission, and in some cases, without even letting you know in advance. That happens after you receive a margin call.

WHAT IS A MARGIN CALL?

A margin call is a demand to bring your margin account into compliance with your brokerage's margin regulations (usually 50%). For example:

Suppose you put $10,000 into a margin account. You now have $20,000 buying power — your $10,000 and $10,000 from your brokerage. Using that money, you purchase 2,000 shares of stock ABC, which is selling at $10. That leaves you with a 50% margin. That way, your investment, divided by the value of the securities, is: ($10,000 / $20,000 = 50%).

Now, let's say that the shares of ABC drop to $9 per share. With 2,000 shares, that is a loss of $2,000. Your new margin percentage is 44%, and your investment is reduced by your losses divided by the value of the securities: ($10,000 ­ $2,000)/($20,000 ­ $2,000) = 44%.

Since 44% is less than the 50% required, your brokerage will issue you a margin call. You can either deposit additional money or sell off some of your securities to bring your margin back to 50%. If you do nothing, your brokerage will sell off your securities for you.

Your brokerage may or may not inform you that a margin call has occurred. They are not required to do so. This could easily damage your investment plans. Fortunately, there are four simple methods for preventing margin calls.

Method 1: Don't borrow the maximum amount

With your brokerage account at the limit of the maximum margin percentage, you are at the mercy of market conditions. Even a slight stock fluctuation could result in a margin call. However, by not borrowing to your maximum margin percentage, you can leave a cushion.

Consider the example I just discussed. Instead of buying the full $20,000 worth of ABC stock, let's say you only buy 1,500 shares or $15,000, which leaves you with $5,000 additional buying power on your margin account. When the stock drops to $9, your margin percentage is 63%: ($10,000 ­ $1,500)/($15,000 ­ $1,500) = 63%. This is still well above the 50% required margin percentage.

Method 2: Diversify your portfolio

When you invest in only a single stock, your entire brokerage account fluctuates with that stock. This problem only worsens when you use margin trading to invest. One really bad day can devastate your entire portfolio. To avoid such possibilities, you should invest in a variety of stocks across several market sectors. That way, you can reduce the effect of the falling price of a single stock.

Instead of buying all ABC stock, let's say you buy 1,000 shares of ABC stock and 1,000 shares of XYZ stock. Both of the stocks sell for $10 a share at the beginning. When the ABC stock drops to $9, your margin percentage is 47%: ($10,000 ­ $1,000)/($20,000 ­ $1,000) = 47%. You would still face a margin call, but a much smaller one. And if the XYZ stock were to go up by $1.00 at the same time, you would not have a margin call at all. Your margin percentage would be 50% ($10,000 ­ $1,000 + $1000)/($20,000 ­ $1,000 + $1000) = 50%.

Method 3: Make regular payments

When you trade on margin, you are borrowing money from the brokerage, and you are charged interest for its use. Although this interest is generally not excessive, it can add up over time and eventually put you below the minimum required margin.

An easy way to get around this is to send in additional money to the brokerage regularly for at least the amount of the interest owed. This will keep your account from suffering a margin call due simply to interest. If you can afford to send more money, you should.

Method 4: Watch your stocks carefully

The most important thing you can do to prevent a margin call is monitor your stocks often. If you are getting close to the minimum margin percentage, you should check them at least daily. This will give you plenty of time to decide whether you need to send in additional money or to sell off some of your securities.

In addition, be sure to monitor your stocks from your brokerage account. This lets you use their numbers to find out how much margin you have left.

WHAT IF IT'S ALREADY TOO LATE?

If you have already received a margin call, you can still minimize the damage. Just follow these steps:

1. Find out how much time you have. Most brokerages will give you two days from the time of a margin call to get your account back into compliance. Check with your brokerage to see how much time they allow.
2. Send in money to cover the call. Because of the time frame, you will not be able to mail in the funds. Instead, you will have to use either a wire transfer or a bank transfer to get the money there in time.
3. If you just do not have the money to send in, sell off some of your portfolio to meet the call. This is better than letting the brokerage sell your stocks for you. Some consider this to be a last resort, whereas others feel it's the first, best option. For example, Investor's Business Daily founder William O'Neil says that "Nine times out of 10 you will be better off, because the marketplace is telling you that you are on the wrong path and things aren't working."

Margin trading may not be as perfect as you first thought, but with a little planning, you can invest with your brokerage's money and avoid the margin call.

Al Hetzel is a freelance writer working out of Dallas, Texas. He can be reached at alhetzel@yahoo.com.

Current and past articles from Working Money, The Investors' Magazine, can be found at Working-Money.com.