Learning Paper Trading With Trading Simulators - Part 5 – Margin Call
Learning Paper Trading With Trading Simulators - Part 5 Margin Call
Overview
In Part 4 we learned about short selling, a useful technique, which can be used to one's advantage if used properly. As usually, you can use your existing account at vivatrader.com to try out all the things we will be talking about. This article will explain what margin call is and how this unpleasant event might occur.
Margin call
I'm sure that every beginner investor heard about margin calls. It sounds mysterious, but it is not, really. As we explored in Part 4, it is possible to borrow money from your broker, or sell stocks short, in which case you have to put up some collateral. Both events can lead to a margin call.
Simply put, a margin call happens when the market moves against you and your dealer requires you to put up more collateral, or pay up your debt. He will call you and tell you that more money is required in your account. Let's explore this in greater details.
Margin call which happens when you shorted stocks
Let's look into the following scenario:
You opened an account with $10000
And shorted 330 shares of IBM at $100.0 (it is the price we will use in this example, in real life it could be different). We will also assume that this security is eligible for reduced margin, so your collateral has to be $42,900.00 (330 shares * $100 * 1.3).
Portfolio value after the order has been executed will look as follows:
Initial cash deposit 10000.00
Current NAV 9980.05
Current value of short stock positions 33000.00
Current Free Cash 80.05
Current Cash Held as collateral 2900.00
Min collateral required 42900.00
Current loan issued by broker 0.00
Margin Call Issued No
Account Details explained
It does look a bit strange did not we just sell stock for 33,000? Then why is the current NAV (Net Asset Value) only $9,980.05? And why is the current free cash only $80.05?
Yes, that is all correct, and this is the kind of details VivaTrader Stock Trading simulator is so good at. Remember from Part Four that when you sell stock short, you have to put up some money as collateral, in our case it's going to be 130% of the proceeds, which is $42,900. Proceeds from this sale are $33,000; it means that you need to put up $9,900 more. And given that you have to pay $19.95 in broker's commissions, you end up with having $80.05 in cash that you can spend (free cash).
Net Asset Value
NAV (or Net Asset Value) is the current value of your portfolio. It is calculated using the following formula:
NAV = free cash + collateral cash broker loan + long assets value short assets value.
It is a very important metrics, which is used by many investors or traders to analyze their portfolio performance.
Margin call event
What will happen if the price of the stock we just bought moves up to $120? Let's look at the account details after that happens.
Initial cash deposit
10000.00
Current NAV 3380.05
Current value of long stock positions 0.00
Current value of short stock positions 39600.00
Current number names held short 1
Current Free Cash 0.00
Current Cash Held as collateral 42980.05
Min collateral required 51480.00
Margin Call Issued Yes
Margin call amount: 8499.95
This does not look good. Essentially this table tells you that according to broker's calculations, you have to have $51,480.00 in collateral, but you only have $42,980.05, thus you have to put up $8,499.95 more, or your account could be disabled, or broker could liquidate some positions (or both). Let's decipher some of the calculations:
Since you are still holding 330 shares of IBM short, its value is 330 * 120 = $39600. You need to have 130% of that in collateral, so $39,600 * 1.3 = $51,480.
You already had $42,900.00 in collateral, but now you have a deficiency, since $42,900.00 is not enough to cover the minimum required collateral. The broker will try to automatically increase your collateral, and since you have $80.05 in free cash, it will be used up. However, $42,980.05 is still not enough, and there's nothing more that can be used for collateral, so a margin call will be issued, and your account might become disabled unless you deposit $8,499.95 cash or cash equivalent.
Can margin call be avoided?
Yes it can. Just do not use up all of your funds and always have some free cash (or long stocks) when you sell stocks short. I encourage you to practice short selling more, until you feel confident that you understand all the details we just talked about.
Conclusion
In this chapter we learned what margin call is and how one can avoid it. I encourage you to enter more sell short orders with various parameters and see what exactly will be happening with each order. Do not forget to check out Account Details before and after each order gets executed.
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