Margin calls: how do they influence short and long positions?
Margin is collateral that the holder of an open position has to deposit to reduce the credit risk of his counterparty.
The clearing house (CH) stands between two clearing firms and assumes the legal counterparty risk for the trade
The CH sets the initial and the maintenance margin, and manages the margining process.
Margining encompasses the entire process of measuring, calculating and administering the collateral that must be put up for coverage of open positions.
Then the profit or loss on the day of a open position is paid to or debited from the holder’s margin account (mark to market).
When the margin account is bellow the maintenance level, the CH demands aditional margin (margin call).
Margin calls can be intraday or after closing.
Margin calls are intended to reduce the default risk of open short or long positions taken by investors.
It can push investors to stop losses before the accumulated losses go out of control.
You would receive a margin call from a broker if one or more of the securities you had bought (with borrowed money) decreased in value past a certain point. You would be forced either to deposit more money in the account or to sell off some of your assets.
The minimum margin requirement, sometimes called the maintenance margin requirement, is the ratio set for:
(Stock Equity - Leveraged Dollars) to Stock Equity
Stock Equity being the stock price * no. of stocks bought and Leveraged Dollars being the amount borrowed in the margin account.
E.g. An investor bought 1000 shares of ABC company each priced at $50. If the initial margin requirement were 60%:
Stock Equity: $50 * 1000 = $50, 000
Leveraged Dollars or amount borrowed: ($50 * 1000)* (100%-60%) = $20, 000
So the maintenance margin requirement uses the above variables to form a ratio that investors have to abide by in order to keep the account active.
The point is, let's say the maintenance margin requirement is 25% - That means the customer has to maintain Net Value equal to 25% of the total stock equity. That means they have to maintain net equity of $50, 000 * 0.25 = $12, 500. So at what price would the investor be getting a margin call? Let P be the price, so 1000P in our case is the Stock Equity.
(Current Market Value - Amount Borrowed) / Current Market Value = 25%
(1000P - 20000)/1000P = 0.25
(1000P - 20000)= 250P
750P = $20, 000
P = $20, 000/750 = $26.66 / share
So if the stock price drops from $50 to $26.66, investors will be called to add additional funds to the account to make up for the loss in stock equity.
An alternative formula for calculating P is P=P_0((1-initial margin requirement)/(1-maintenance margin requirement)) where P_0 is the initial price of the stock. Let's use the same information to demonstrate this: