Time Value of Money
The concept that money you have now is more valuable than the same sum in the future.
To understand what a margin call is, you have to know what it means to trade on margin.
Sometimes referred to as ‘leveraged trading’ or just ‘leverage’, trading on margin is when you trade using borrowed money. Doing this allows investors to buy much more of a particular asset than they would otherwise be able to.
The money they use is usually borrowed from a broker. In order to borrow, investors have to put down some of their own cash or other assets as a form of collateral. This collateral is known as ‘margin’.
The reason a broker asks for margin is so that they don’t lose the money that they’ve lent you to trade with.
So if the asset you have invested in using borrowed money loses the value of the margin you put down, the broker will ask you to give them more cash or assets as margin. If you don’t do this, the broker will liquidate the position in an effort to make sure they don’t end up losing money.
Imagine you have a broker that lets you trade on margin of 25 per cent. That means you have to put down a minimum of 25 per cent of the value of the trade that you are going to make.
Using this broker, you buy some shares worth £1,000. You put down £500 as margin and the broker lends you £500.
Unfortunately for you, those shares fall in value to £600. That means the broker’s original £500 is still there but you now only have £100 in the trade.
In percentage terms, that means you also now only have ⅙ - 16.66 per cent - as margin. This is below the margin level required to keep the trade open.
To keep the trade open, you would have to deposit assets or cash that would bring your margin back up to the 25 per cent level that the broker requires. If you fail to do that then broker will liquidate your position and recoup the money that they lent to you.
