- Introduction to margin calls
- Trading on margin
- What's the risk?
- So, how exactly do you trade on margin?
- Scenario 1
- Scenario 2
- Can anyone do this?
- What are the benefits of trading on margin?
- And the cons?
- What triggers a margin call?
- 4 steps to avoid or prepare for a margin call
- 1. Borrow less than the maximum
- 2. Diversify
- 3. Set your own ‘maintenance margin’
- 4. Monitor your account regularly
- What happens if you can’t pay a margin call?
As an investor, a margin call is one of the more stressful experiences you might go through. It basically means you owe your broker money – and in a hurry!
Let's take a closer look at what a margin call is, what might trigger it, and – most importantly – how to avoid getting one yourself.
Introduction to margin calls
A margin call is a request from your broker to deposit additional money into the margin account you hold with them. It generally occurs when shares you have purchased by trading on margin have fallen, requiring you to top up your equity share.
There's a bit to unpack in that paragraph.
Trading on margin
First, we'll start with what it means to trade on margin. This is when you buy shares using a combination of your own money and money that you borrow, generally from your broker. The borrowed money gives you the capital to purchase far more shares than you otherwise could have, potentially magnifying your gains.
However, trading on margin also comes with increased risk.
What's the risk?
In exchange for the extra cash, your broker will require you to set aside enough collateral – in the form of shares – to cover the loan. The shares you borrow against must be from your broker's approved securities list (ASL). Similarly, the money you borrow can only be used to buy securities from the ASL.
Unfortunately for us all, share prices can go down as well as up. If the price of the shares you've used as collateral suddenly drops, your assets may no longer be worth enough to cover the loan. In this case, your broker would issue a margin call.
This demands that you either repay part of the loan with cash, buy up more shares to increase your collateral or sell some of the shares you already own (probably at a loss).
It can be an uncomfortable experience for any investor, and one that may end up costing a lot of money.
So, how exactly do you trade on margin?
A better question might be, why would you?
Well, although margin calls can be tough to deal with, margin trading allows you to magnify your potential returns greatly.
This is best illustrated with a simplified example.
Let's say you already own $10,000 worth of Woolworths Group Ltd (ASX: WOW) shares and would like to invest a further $10,000. On the one hand, you could pay the $10,000 cash for the shares upfront out of your own pocket. Alternatively, you could trade on margin and borrow most of the money required to buy the extra shares.
Woolworths is on your broker's ASL, and your broker specifies that you can borrow up to 75% of the value of your existing Woolworths holdings. This is what's referred to as the security's loan-to-value ratio (LVR).
This means that by putting up just $2,500 of your own money now and then borrowing the remaining $7,500 (the maximum LVR), you could still walk away with $10,000 worth of new Woolworths shares. You could also use your loan to invest in other companies if they are on your broker's ASL.
Now, let's say the Woolworths share price suddenly shoots up by 10%.
If you had used your money to buy the new shares, those shares would now be worth $11,000. If you decided to sell them, you could pocket the $1,000 profit (less transaction fees) and realise your 10% gain. Not a bad return on investment.
But what if you had instead decided to trade on margin?
In this scenario, you could invest just $2,500 of your own money and then borrow the remaining $7,500 by using your existing Woolworths shares as collateral. You would still be left with the same $10,000 worth of new Woolworths shares.
After the Woolworths share price shoots up 10%, these additional holdings would also be worth $11,000. And if you decided to sell your shares, repay the loan, and then pocket your profit? You would have made the same $1,000 (less your interest repayments and account fees).
However, because you only initially put up $2,500 of your own money, you've earned a return of 40% – your $1,000 profit divided by your $2,500 investment. This means that, by trading on margin, you have managed to quadruple your return on investment!
Can anyone do this?
Margin trading is open to anyone. However, you should understand the risks before opening a margin account.
Although some brokers will allow you to open an account with only small amounts of capital, margin trading still best suits investors with higher risk appetites. And enough extra cash to meet any unexpected margin calls.
If you are interested in margin trading, ensure it aligns with your long-term investing goals and personal risk appetite. And reduce your risk by borrowing less than the maximum LVR for securities. While reducing your potential upside, it also reduces your chances of receiving a margin call.
What are the benefits of trading on margin?
As we've already discussed, the main upside to trading on margin is that you can significantly magnify your returns, potentially helping to achieve your investing goals faster.
And, because margin trading gives you access to increased funding, you can now afford to diversify your investments. Instead of buying shares in just one or two companies, you can invest your borrowed money across four or five. Diversifying is one of the best ways to reduce your overall portfolio risk. This is because it makes you less reliant on any one ASX stock's performance to grow your wealth.
Plus, it's worth adding that interest paid on an investment loan is generally tax-deductible, reducing your overall taxable income.
And the cons?
Unfortunately, margin trading also magnifies your potential losses. A falling market can trigger a series of margin calls, costing investors serious amounts of money.
Just as you top your account up enough to meet the demands of the first margin call, share prices might fall again, triggering a second margin call. And this process can go on and on.
Besides the risks, it can also be expensive – so always shop around for the lowest fees. Before taking out a margin loan, work out how much of a return you would need to generate from your investments to at least cover your interest payments and account fees, and then think about how achievable that is.
What triggers a margin call?
A margin call is triggered when the security value of the assets you have provided as collateral drops below the amount you borrowed. The 'security value' is the total value of your shares multiplied by their LVR.
For example, the starting security value of the $10,000 worth of Woolworths shares you already owned was $7,500 because Woolworths shares had an LVR of 75% (according to your broker).
As the market moves, the security value of your Woolworths shares might increase or decrease. If it drops below the outstanding balance of your loan, your broker will issue a margin call.
Brokers may often grant investors an additional buffer on top of the LVR – sometimes 5% of the portfolio value. This means that a margin call won't be triggered until the total security value plus the buffer drops below the loan amount.
4 steps to avoid or prepare for a margin call
1. Borrow less than the maximum
Just because you can borrow as much as the LVR allows doesn't mean you have to. Borrowing less means you create an extra cushion in your margin account – remember, it's not until the security value drops below the outstanding balance on your loan that a margin call is triggered. The lower the loan amount, the less likely you will get a margin call.
As we've already discussed, diversifying is a great way to reduce the overall risk of your portfolio. This can help you both prepare for (and even avoid) a margin call.
On the one hand, if you use a diversified portfolio of ASL shares as collateral, it becomes less likely to drop below the minimum required security amount unexpectedly.
And if you use your borrowed money to buy multiple different securities – rather than just one – you are less reliant on any single investment to generate your returns. If some investments have increased in value while others have declined, you can take profit from your better-performing stocks and use that to meet any unexpected margin calls.
3. Set your own 'maintenance margin'
Sometimes, it helps to set your maintenance margin. This is a level of capital you maintain in your account that exceeds the broker's minimum required security value. If you leave extra cash in your margin account to act as a buffer, you can avoid any unpleasant margin calls from your broker.
4. Monitor your account regularly
The most important thing you can do when trading on margin is monitor your account. Check your security value daily and frequently adjust the leverage you use depending on how risky you think the market is. If conditions are particularly volatile, or prices are falling, repay some of your loan to reduce your leverage or add extra cash to your account as a precaution.
What happens if you can't pay a margin call?
The worst-case scenario is that you receive a margin call from your broker and cannot pay the amount requested.
Because margin calls must be met immediately, your broker may force you to sell some of your shares if you don't have the cash readily available.
This may mean you crystallise unrealised losses on your investments and miss out on potential future growth opportunities.