I wish I knew what a margin call was, but I’m too embarrassed to ask
If you borrow money to invest and it all goes wrong, you could face a “margin call” from your creditors. But what exactly does that mean?
When investors buy shares or other financial assets, they can borrow money with the aim of boosting their returns. However, if things don’t go their way, they may face a “margin call”, and be forced to sell their holdings for a large loss.
Before we explain what a margin call is, we need to look at why someone might borrow money to invest in the first place. The easiest way is to compare it with using a mortgage to buy a flat.
Say you buy a flat for £100,000. You put down a 10% deposit – £10,000 – and borrow the other £90,000 from the bank. A year later, house prices have gone up. You sell the flat for £110,000. The price of the flat has gone up by 10%. But you have made a 100% profit. How? Once you repay the £90,000 to the bank, you are left with £20,000. You only put in £10,000 of your own capital. So you’ve doubled your money.
Of course, it cuts both ways. If house prices had fallen by 10% – heaven forbid! – the flat would have been worth just £90,000. All of the sale proceeds would have gone to the bank, and you’d have lost your original £10,000 – a 100% loss.
So borrowed money amplifies movements in the underlying asset price. This is why it’s known as “leverage” or “gearing”.
When an investor borrows to bet on shares, they also put down a deposit. In this case, it’s known as “margin”. The “margin” is there to protect the banks who lend the money.
A “margin call” happens when the margin available to cover any losses falls below a certain level. At that point, the banks demand the investor puts up more “margin” in the form of cash or other collateral. If they fail to do so, the banks may have to sell their holdings to reduce their own risk.
Day traders and spread betters often get margin calls. But it also happens to institutional investors, such as hedge funds. The risk with such margin calls is that if one heavily leveraged seller is forced to sell their shares, this might trigger margin calls for other investors, resulting in a domino effect.
This is why central banks have been known to step in when “systemically important” institutions have suffered margin calls in the past.
To find out more, subscribe to MoneyWeek magazine.