Whenever you enter into a trade or investment, it’s always critical that you understand the underlying risks. Without a clear understanding of the downside risk, the possibility of getting into financial trouble is a lot higher. The investment risk or downside risk of a trade is always higher when you start leveraging your positions. Unfortunately, this is a lesson that many beginners learn the hard way.
It’s quite common for traders and investors to open up a margin account with their brokers. These types of accounts essentially allow you to obtain a loan from the brokerage company to leverage your investments. The upside is nice because if a position works in your favor you are earning more off of the borrowed amount. However, when you make a trade on margin and a position moves against you, things can get disastrous quickly. In those scenarios, getting a margin call is typically the result. We want you to avoid margin calls and understand the risks of trading with a margin account, which is why we are going to take an in-depth look at them below.
What Are Margin Calls?
Whenever you open a margin account, you are opening an account that gives you the opportunity to purchase securities with borrowed money. That means that if a position goes against you, you can end up losing more money than you initially had in the account. The broker will require that you keep a certain amount of money or securities in the account at all times. Generally speaking, most brokerages that offer margin accounts allow their clients to borrow up to 50% of the purchase price of a marginable security. That means you can essentially double the amount of stock you would normally be able to buy with a margin account. However, if and when your account value falls below the broker’s requirements, also known as the maintenance margin, you will find yourself in a margin call.
The only way to get out of a margin call is to either deposit more cash immediately or sell the securities in the account. That usually means selling a position at a significant loss. The problem with margin calls is that many people don’t understand how they work. They end up opening a margin account without realizing the true implications of it. This is a recipe for failure. Always make sure you understand the financial risks of opening a margin account and trading on margin before you move forward. It’s also important to understand that borrowing funds on margin means you will be paying margin interest on the money you borrow. As you can tell, things can get bad quickly if you aren’t careful using margin in your trading and investing.
How to Avoid a Margin Call
There are a few ways to avoid getting a margin call, with the simplest one being avoiding opening a margin account entirely. However, if your goal is to day trade, a margin account will make your life a lot easier. That’s because, with a margin account, you will have the opportunity to trade with unsettled funds versus having to wait for your next trade. This allows you to avoid the settlement date violations that restrict a cash account while you are day trading.
If you do decide to trade on margin, there is no guarantee that you can avoid a margin call entirely. Unfortunately, most investors don’t read the margin agreement before opening a margin account. We strongly recommend reading the entire margin agreement in detail for your brokerage firm before moving forward. That way, you are aware of the risks and stipulations associated with buying stocks or securities with borrowed money.
Managing your risk and being extremely selective of your trades is one way to attempt to avoid margin calls. With that being said, there is no guarantee that you will avoid a margin call if you borrow money from your brokerage on margin. Margin loans can dramatically increase your market risk and can leave you reeling since your downside is increased as well. It’s always a good idea to have some money set aside for a margin call in the event that a position moves sharply against you. The last thing you want is to be unable to pay a margin call, since it can negatively affect your credit score and even lead to lawsuits if you aren’t careful. That’s why paying a margin call should be the number one priority if you find yourself in that situation.