The Margin Call Guide: What is it and How to Avoid It?
Margin calls only occur in certain circumstances. One element is a margin. As a trader with a margin (also called a loan), you have to be wary of the equity in your account. You can receive a margin call from your lender when you don't have enough equity. The lender uses the margin call to discuss how you can restore the equity.
This is a simplified explanation of a margin call, but how can you avoid it? We researched every detail of how a margin call works. In this guide, we will explain the potential triggers of a margin call. You’ll get first-hand knowledge on how to avoid and prevent a margin call from your lender.
The Margin Call: Ultimate Definition
Many traders prefer to use loans to buy assets when they don’t have access to liquid cash. This way, your total trading securities are a mix of your own money and lent capital. A margin call is a literal call (or other communication) from your lender. In most cases, the lender is a broker from an established platform. It’s now more popular than ever to use online brokers. This is especially true if you’re trading cryptocurrency.
Borrowed funds are your margin. When you accept it, you also agree to a maintenance margin. This is a percentage of the equity in your account. You must keep your account’s equity above the maintenance margin. In most cases, this percentage is around 25% to 30%. Some brokers ask for a maintenance margin as high as 40%.
If your equity falls below this percentage, you receive a margin call. The broker then demands that you agree to a plan to improve your equity. They (the broker) want to make sure that if you continue to lose money, they will still receive reimbursement.
Your money, which can be in the form of stocks or other assets, is collateral for the margin. Money that isn’t in your trading account also counts. Knowing this, there are a few different options you can take to prevent a margin call.
1. Use Your Cash
You can calculate how much money will make up the missing percentage of equity. Then, you can deposit extra money into the account from your own savings. This will go towards fixing the maintenance margin.
2. Transfer External Assets Into the Account
You might have shares, stock, or investments held in other accounts. You can break these off or add them together to meet the maintenance margin. Then, transfer them into the account that lost equity.
3. Sell Other Assets
You can also sell off some of your remaining securities to make up the difference. If you have suddenly lost equity, it might be due to market volatility. If there is a flux in the value of assets, you’ll probably be selling at a lower price than usual.
The broker will give you a time limit to reply to them and take one of these actions. This period is usually 2 to 5 days. If you don’t satisfy the maintenance margin at that time, the broker will take matters into their own hands. Since they can’t take external money or assets, they will sell or liquidate the securities in your account. They can also liquidate your assets outright.
They can do this without having to notify you or ask your permission. Most will let you know as a professional courtesy, but it’s not a given. You should also be aware that a broker can increase the maintenance margin at any time (depending on the broker).
Like any other loan, your margin comes with interest attached to it. You need to factor the interest percentage into the maintenance margin as well. These are all risks you take when enlisting the help of a lender or a firm for a margin. Remember to stay updated on the terms and conditions of your deal.
You can read these terms in the initial margin agreement. You can sometimes negotiate the terms of the agreement with your broker or their firm. For example, most stock brokers will check your maintenance margin at the market close. Stock market closing hours can vary, depending on the day of the week and special occasions.
You can instead ask for an intraday margin, which will be checked at a different time. This is sometimes called a real-time margin. If you’re a day trader, this type of margin check-in can suit your needs much better.
What Triggers a Margin Call?
Any instance that lowers equity can trigger a margin call. This includes scenarios like:
The market value of the assets in the account drops. This is the most common trigger.
A decrease in market price is caused by the following:
- Inflation and deflation
- Market demand vs. supply
- You haven’t used a stop-loss order to minimize loss. You should always use a stop-loss order or another risk management strategy. This will protect you from losing too much equity. It also enables you to take more calculated risks on trades.
- You haven’t made enough profit to meet the interest on the margin. If you let your trading go stagnant, you might not make enough to meet the agreement.
Suggested Reading: Stop Loss Order Explained
An Example of a Margin Call
Let’s explore a scenario of a margin call and how it can be resolved. In this example, our margin investor is Cheryl. Cheryl is new to trading and has an account with a total of $20,000 in stocks. She borrowed $5,000 of the funds from a broker. The other $15,000 is self-funded. With this money, Cheryl buys 100 stocks worth $200 in value from a single company.
We use the following formula to determine the account value:
Account Value = (Margin) / (1 - Maintenance Margin)
Cheryl’s current margin agreement with her broker is a 25% equity maintenance. Cheryl can calculate her account’s value with the formula:
(5,000) / (1 - 0.30) = 7,142.85714
We can round this figure to $7,143. If Cheryl’s equity falls below that number, she’ll receive a margin call quickly. Unfortunately for Cheryl, the parent company of the stock she has invested in just experienced a massive crisis.
The company, called CinemaFlicks, made a terrible strategic decision. It raised prices and changed settings on its subscription service. This alienated many customers from their services. At the same time, a competitor called MovieMatch launched a new subscriber program. These two things killed market demand for the company’s stock. The price went from $200 in value to $55 in value.
This makes Cheryl’s current equity just $5,500. She will have to make up the difference of $1,643. Her broker gives her a margin call and they discuss what to do. Cheryl doesn’t have other stocks to sell. The price of her existing CinemaFlicks stock isn’t likely to improve anytime soon.
Cheryl’s broker understands but needs to make sure the maintenance margin is satisfied. He asks that she does so in the next five days. After some calculations, Cheryl decides to transfer her own cash into the account.
How to Avoid a Margin Call
There are several ways Cheryl and other margin investors can avoid margin calls. The key to doing so is learning how to manage risk. Cheryl ignored some of the best risk management strategies.
- Invest in a diversified portfolio: Cheryl immediately put all her funds into one investment. Even though she thought the company was stable, this increased her risk.
- Use stop-loss orders and other conditional market order: Cheryl’s CinemaFlicks stock tanked almost overnight. She couldn’t have been fast enough to manually put out a market order for her stocks before she lost too much money. A stop-loss order automatically and immediately sets a market order for stock. It does this when a security reaches a trigger price and minimizes further loss.
- Stay updated on market prices: Even with a stop-loss order, it’s important to stay informed on market changes. Cheryl didn’t put out an alert for breaking news on CinemaFlicks. If she had, she might have acted faster.
- Keep your leverage manageable: You should make sure the amount you borrow is reasonable. In the worst-case scenario, you will have to pay a large sum of money.
Does YouHodler have a Margin Call?
Yes. YouHodler has margin call (or as we call it, Price Down Limit) on our platform. YouHodler reserves the right to sell the collateral in the event of the collateral cryptocurrency price decreasing below a certain limit. However, YouHodler offers very competitive margin call levels.
In the event of a margin call, clients can buy almost the same amount of cryptocurrency for fiat that they received from the loan earlier. Furthermore, we have multiple features for crypto-backed loans and Multi HODL that help clients manage their risk.
Depending on the terms of the deal, clients can set a “take profit” level so their loans close automatically and can avoid any potential margin call scenario. We also offer an “Extend PDL” feature which allows users to deposit more collateral to avoid a margin call.
So head to YouHodler today to experiment with these risk management strategies and discover new ways to activate your crypto.