Margin Calls in Investment Explained

So you got a margin call. Join the club. It happens to the best of us. It also happens to me sometimes. It’s not the end of the world as long as you handle it with confidence and equanimity. “Easier said than done,” you say, but trust me, by about the third one they get routine.

You may be wondering why your account, which looked wonderful yesterday, has suddenly betrayed you, sending your buying power into the negative zone and rousing the ire of the financial institution backing you. It probably happened, not as a result of any action on your part, but in response to external factors. There are a few possibilities, and when you’ve determined the reason for the margin call, you can handle it.

First off, note that it is wise to have wire transfer prearranged with your trade account and another bank account. This will allow you to wire emergency funds if needed. It may help you avoid making difficult decisions regarding liquidation.

To my surprise, the brokerage I use actually has a FedEx account number with which account holders can overnight checks. The FedEx fee is charged to the brokerage. This is a nice service, and one I have used because I haven’t set up wire transfer yet. (I’m lazy).

Of course you can avoid a margin call by leaving a large amount of cash in your trade account relative to the positions you have open. Trade accounts do not earn much interest, so it is far preferable to have a fairly tight margin in your trade account, but a substantial reserve of cash in another, higher interest account from which you can wire transfer funds. In theory, this should work, but the problem is a little thing called human error. Do the best you can to avoid margin calls, but be prepared to handle them.

1. You got assigned an option contract.

If this is the case, you will need to close the long or short stock position resulting from the assignment. This may solve the problem, and if so, then you don’t need to consider anything else. If the assigned option was part of a hedged spread, you need to think carefully about which will be more profitable- selling the hedge or exercising it? If you no longer have a negative buying power after handling the stock position, then you may want to hang onto the hedge as a speculation. However, odds are that if you got assigned, that means it’s a good time to cut your losses by closing the hedge.

2. Prices fluctuated.

Long stock and long options increase your buying power, as does cash. Short stock and short options do the reverse. If a short stock or option suddenly skyrocketed, you may have a margin call because the amount of cash it would take to by that back is more than you can “afford” according to the rules of your brokerage. Alternatively, perhaps the long options or stock in your portfolio decreased in value.

With long stock, it’s pretty much a coin toss on whether the price will go up or down. However, note that options prices will, all other things being equal, decay over time. If you have a lot of long options, make sure you understand that your buying power will decrease over time as a general rule. Price changes and fluctuations in volatility will sometimes give you more buying power, but do not be tempted to use that to open more positions. Long options, like bread, get less and less enjoyable to have as the days go by.

Short options, of course, will generally take up less of your buying power as time goes on. As a retail options trader, I count on this to make a living. It works.

But it isn’t without risk.

Yesterday, I watched the options against me move farther out of the money, which is a good thing. It increases the probability that come expiration Friday, I’ll walk away scott free with all my credits on those contracts turning from mere revenues into actual profits. However, because of the suddenness of the price changes, both the puts and calls against me increased in value! This was purely a function of volatility; when stocks trend one way or another, then only puts or only calls will decrease. Volatility (uncertainty) affects both equally, at least on most underlyings.

I opted not to make any position adjustments, knowing that the volatility would decrease by this morning, and it did. I did not receive a margin call yesterday, but then this afternoon the volatility spiked again (that’s very common in the afternoon). In my inbox was a little note from my brokerage warning me to send money, liquidate, or be liquidated.

The key at this point is to remember the wisdom of “The Hitchhiker’s Guide to the Galaxy”. In case there are any intelligent people who haven’t read it (stop laughing), I’ll remind you that the phrase to which I refer is “Don’t Panic”.

If you can wire transfer to meet a margin call, that is the optimal solution unless, of course, there are positions you weren’t to attached to anyway. If you were thinking about closing a position to take a profit or cut a loss, this is the time to do it. Be careful to calculate the buying power effect of each adjustment before doing it. Try to make as few adjustments as possible and limit yourself to those that free up a lot of buying power but don’t decimate your potential profits or severely exacerbate your losses.

Think creatively; keep an open mind and consider closing parts of a position, rolling positions between months, or purchasing hedges for naked options. All of those could potentially help your buying power without forcing you to abandon your strategy. Remember that the absolute worst thing that can happen is that your brokerage will have someone liquidate part of your account for you. It is better to let that happen then to make foolish trades out of panic.

Today I managed to scrape by with just a couple of minor debit adjustments. Sure, I could have taken even more debits and made extra super sure I won’t get a margin call again on Monday, but why? Monday is a new day, and will bring new opportunities as well as new risks. Life is too short to live in fear of margin calls.

And besides, you lose a lot of money that way.

That, I can tell you from experience.