Margin Calls
When a stock is bought using a margin transaction, the investor provides a portion of the initial investment (the equity) and borrows the rest (the margin.) The initial margin cannot exceed 50% of the total transaction value under current regulations.
After purchase, the margin remains constant (excluding interest payments) but the amount of equity fluctuates disproportionately with the stock price. If 50% initial margin is used, a 10% change in the share price will result in a 20% change in the equity value.
The Federal Reserve also sets a minimum maintenance margin requirement, which is currently 25%. This means that if the equity falls below 25% of the total security value, the securities must be sold to repay the margin.
Consider a 50% margin purchase of 100 shares of a $100 stock. The investor’s initial equity (and margin) is $5,000. At future points, the equity will equal 100P – $5,000, or 100 shares times the current share price, less the margin amount.
The investor will receive a margin call when the value of the equity falls to 25% of the total security value, which can be calculated as follows:
(100P – $5,000)/100P = 0.25, which algebraically becomes
100P – 5,000 = 25P
75P = 5,000
P =Â $66.67
If the stock price falls to $66.67, the investor will be required to sell the shares and repay the initial $5,000 margin. Only $1,666.67 of the original $5,000 would remain – a 66% loss.
For more information, see all articles on: Uncategorized See also:
The Intelligent Investor: The Classic Text on Value Investing
Financial Statement Analysis: A Practitioner's Guide, 3rd Edition
Managing Investment Portfolios: A Dynamic Process (CFA Institute Investment Series)
