What is a margin call?

What is a margin call? It's a question we get asked all the time, so we've put together this guide on trading margin calls and what to do if you receive a margin call.

Introduction to Margin:

Whether you're taking out a mortgage to buy a house or a student loan for college, borrowing money is how we finance big purchases.

Could you imagine having to save €200,000 in cold hard cash to buy that starter home?

Most people would rent for the rest of their lives! Borrowing money allows us to use future income today, an important focus in the life cycle theory of personal finance.

But enough with the examples of personal finance. We don't want to buy houses or pay for college with our trading accounts, but that doesn't mean we can't borrow cash. Brokers often lend investors cash in the form of margin.

By lending money against their current capital, traders can leverage their returns and take home double the usual profits. However, no investment is without risk - and margin doubles that risk. Using margin can increase your returns, but it has several consequences, including the possible forced sale of your shares or other assets.

What is margin?

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Margin simply means borrowed money. When you trade on margin, you use both your own capital and cash from your broker. When you trade on margin, the cash and securities in your brokerage account serve as collateral for a loan you receive from the broker.

For example, let's say you want to buy $4,000 worth of AAPL stock, but you only have $2,000 in your trading account. By using margin, you can borrow $2,000 from the broker using the money already in your account as collateral.

After a month, your investment may be worth $5,000 and you decide to return the loan to the broker. You pay back $2,000 that you borrowed (plus interest, fees and/or commissions) and keep $3,000, including $1,000 in profits. Congratulations, you have now doubled your profits!

Due to the European regulation ESMA, brokers for FX and CFD trading are only allowed to offer a maximum leverage of 1:30 for private traders. Professional traders can get a higher leverage. Providers outside the European Union continue to offer a leverage of over 1:500.

Once you have executed your trade, you need to keep your account at a level known as 'maintenance margin' to avoid the dreaded margin call.

How does maintenance margin work?

If you buy $4,000 worth of AAPL on 50% margin, you're on the hook for the $2,000 you borrowed, regardless of how the investment performs.

If Apple has a bad earnings report and your investment loses $1,000, you're left with $3,000 in your account. Not ideal, but not terrible either, right? However, since $2,000 is borrowed and belongs to your broker, your remaining equity is actually only $1,000.

And since $1,000 falls below the 30% maintenance threshold, your broker will issue a margin call. You do not want to be issued a margin call.