The following post was originally published on Debt Free Guys
Margin investing and trading can be volatile.
A couple of weeks ago, we started a two-part series about stock investing and trading rules to educate our readers of potential trading violations they, their broker or financial advisor can cause. Trading violations can happen by mistake, so hopefully this series eliminates those mistakes for you.
The following investing and trading violations pertain to margin trading violations. Margin accounts are taxable accounts that allow traders to borrow from their broker/dealer against the trader’s securities. The securities in the account act as collateral. The amount a trader can borrow is based on a percentage of the value of the securities in the trader’s account. Some securities are not marginable. Others that are marginable are so by varying percentages. Each exchange sets its own margin limits for each security. Each broker/dealer can set more restrictive margin limits on each security it lends against, but cannot choose less restrictive limits than those dictated by the stock exchanges.
Margin Maintenance Call
Margin Call is not only a good movie, but a trade violation. As mentioned above, only a certain percentage of any marginable stock is marginable. Broker/dealers calculate the amount of margin a trader has considering all the securities with their varying margin ability in a particular account.
Each broker/dealer has its own formula for calculating account-level margin ability and the formulas are often quite complex. Most broker/dealers, however, typically provide traders with the amount of available margin they have on their account online. When the trader falls below certain limits due to a drop in market value, meaning they become over-leveraged, a margin maintenance call occurs.
This means that the trader must either immediately deliver funds to the account or immediately sell a proportional percentage of marginable securities. Broker/dealers always reserve the right to electively sell a client out to remove the margin maintenance call. That’s because markets can drop quickly and the more over-leveraged a trader becomes, the more risk a broker/dealers assumes. If egregious and widespread enough, margin maintenance calls can have a ripple effect on the overall market and economy.
Fed Margin Call
A Fed (short for Federal) Margin Call occurs at the point of purchase. That is a margin trader purchases more marginable stock in their account than they have available margin.
For example, a margin trader purchased $10,000 of a marginable stock when they had $3,000 cash in the account and needed $5,000 cash to cover their portion of the margin stock purchased. Again, the trader must either immediately deliver funds (minimum $2,000) to the account or immediately sell a proportional percentage of marginable securities or they may be at risk of being sold out to cover the shortfall.
Though all traders who sign up for margin accounts sign a contract that gives the broker/dealer the right to sell a client out of Fed margin calls, this almost always makes a trader angry because the broker/dealer does not necessarily choose the securities the trader may have wanted to sell.
To avoid these or any kinds of investing and trading violations, make sure you understand what you’re getting yourself into when doing any amount or kind of trading. It’s simply best to avoid these violations from the beginning.