subject: Learning Paper Trading With Trading Simulators - Part 6 – Margin Calls explained continued [print this page] Learning Paper Trading With Trading Simulators - Part 6 Margin Calls explained continued
Overview
In Part 5 we learned about margin calls, and we looked at margin calls that happen when you sell stock short. This article will explain how margin calls can occur when you buy stocks long. Can it really happen? Yes, it can, and leverage is the word. You can use your existing account at vivatrader.com to try out all the things we will be talking about.
Margin Account and leverage
You can open either cash or margin account with your broker. Cash account means that you will only use your cash to purchase securities. You will not be able to sell stocks short as well. Margin accounts, on the other hand, allow for borrowing money from your broker to finance a purchase of the security. It means that if you have $10000 available in your account, you will be able to buy securities for up to $20000 and more. It is also called leverage, and it is a great tool which can amplify your profits or magnify losses.
Margin call
As we discovered in Part 5, 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. Depending on the brokerage and type of service it provides, somebody might call you on the phone and tell you that more money is required in your account. Or they may not call and simply liquidate some of your positions to bring margin into required level. Let's explore in greater details what happens when you use leverage and market is not going your way.
Margin call which happens when you buy stocks
Consider the following scenario:
You opened an account with $10,000
And purchased 330 shares of IBM at $100.00 (it is the price we will use in this example, in real life it could be different).
Portfolio value after order has been executed will look as follows:
Initial cash deposit 10000.00
Current NAV 9980.05
Current value of long stock positions 33000.00
Current number of names held long 1
Current Free Cash 0.00
Current loan issued by broker 23019.95
Max broker loan allowed 23100.00
Unused loan amount 80.05
Margin Call Issued No
Account Details explained
As you can see, although we only had $10,000 in cash, we were able to buy 330 shares of IBM, which cost us $33000. So we borrowed $23019.95 from the broker.
Depending on the security and other factors, we will be able to borrow a different amount for any particular transaction. In this case we were able to borrow up to 70% or $23,100.00. We only needed $23,019.95 though ($33,000.00 - $10,000.00 + $19.95 in commissions).
So, despite the fact that we only had $10,000 in our account, we were able to purchase $33,000 worth of IBM stock, and we still have $80.05 available.
Interest payments
There is one caveat though, which VivaTrader's Stock Trading Simulator exposes rather well: you will be required to pay interest to your broker on every borrowed dollar; the interest payment is calculated daily and is paid every month. Look at your monthly statement to see how much you are paying.
Margin call event
What will happen if the price moves to $95.00? Let's look at the account details after that happens.
Initial cash deposit 10000.00
Current NAV 8330.05
Current value of long stock positions 31350.00
Current number of names held long 1
Current Free Cash 0.00
Current loan issued by broker 23019.95
Max broker loan allowed 21945.00
Unused loan amount 0.00
Margin Call Issued Yes
Margin call amount: 1074.95
Basically, it tells us that the value of your long stock positions decreased in value (330 shares * 95 = $31,350. But it also means that your maximum broker loan decreased too! Now it would be 0.7 * $31,350.00 = $21.945.00.
But you already borrowed $23,019.95. Now you have a deficiency and have to put up more money in your account, or it might become disabled, or you broker might liquidate one or more of your positions in order to meet the margin requirements.
Can margin call be avoided?
Yes it can. Just do not borrow as much money and always have some free cash. I encourage you to play around with leverage more, until you feel confident that you understand all the details we just talked about.
Conclusion
In this chapter we learned that margin call can occur if excessive leverage is used and market moves against your long positions. Do not forget to check out Account Details before and after each order gets executed.
