Understanding margin calls and 4 ways to avoid owing money to your brokerage firm

• A margin call occurs when the equity in your investing account drops to a certain level and you owe money to your brokerage firm.
• Margin calls must be satisfied by depositing cash into the account, or by making up the difference you owe by selling off assets or depositing other assets into the account.
• Using margin can increase the potential return but also magnify your losses.

A margin call occurs when the value of your brokerage account falls below a certain level. This level is known as the margin requirement and means that the investor is required to deposit more money into the account, sell off some of the investments, or add more marginable assets if reached. "The best way to describe a margin call is that you owe your investment platform or brokerage money," says Robert Farrington, founder of The College Investor.

Within the context of investing, margin is the practice of taking a loan from the brokerage firm for the purpose of buying stocks and other assets. Margin can increase the buying power for an investor by allowing them to make larger investments and higher potential profits. "Margin is an incredible tool to provide investors with access to additional capital," says Dr. Hans Boateng, founder of The Investing Tutor. "It works wonders in an upward market. It becomes dangerous in a downward market if you don't have savings in the event of a margin call."

How margin calls work

There are different types of margin calls and requirements based on what type of account you have and the type of asset that you may be trading. Regardless of the account type or what you may be investing in, once a margin call has occurred, you'll be required to bring the account back to the minimum through the methods mentioned previously. If the margin call is not met quickly enough (usually between 2 to 5 business days) then your brokerage may sell out of your positions, which could result in a taxable event.

Quick tip: A maintenance margin requirement is the total amount of capital that must remain in an investment account in order to hold an investment or trading position.

There are three main types of margin calls: maintenance margin calls, Regulation T calls, and minimum equity calls. Each of these margin calls can be triggered for different reasons. Here's a breakdown of each below.

Maintenance margin call: A maintenance margin call refers to the margin requirement to stay in a position. Once you have met the initial margin requirement of 50%, the Financial Industry Regulatory Authority (FINRA) requires that brokerages set a maintenance requirement of at least 25% for the remainder of the trade and allow brokerages to be even more restrictive. This is sometimes known as the "house requirement" and most brokerages set their maintenance requirements between 30 to 40%.

Let's use an example where you have $10,000 invested in company ABC: If your brokerage sets the maintenance margin requirement at 25%, it means that the equity in your account must not fall below $2,500.

Remember, a margin account will consist of the equity, which is the amount of cash you have plus the amount that was loaned to you. Therefore, the total account balance would have to be $7,500 to receive a margin call ($5,000 margin loan + $2,500 remaining equity) because the value of the loan has not changed.

Quick tip: Some brokerages may adjust their maintenance margin requirement based on market volatility and other factors.

Here are a few scenarios using a 25% maintenance margin requirement with $5,000 in equity and $5,000 in margin.

• If account value drops 10% down to $9,000 = No maintenance margin call
• Equity = $4,000
• Margin balance = $5,000

• If the account value drops 30% down to $7,000 = Maintenance margin call
• Equity = $2,000
• Margin balance = $5,000
• You must now add at least $500 to the account

• If the account value drops 40% down to $6,000 = Maintenance margin call
• Equity = $1,000
• Margin balance = $5,000
• You must now add at least $1,500

Quick Tip: Initial margin and minimum maintenance margin are different. The initial margin is the required amount to enter the trade, the maintenance margin as the title suggests is the ongoing amount needed to maintain the position.

Regulation T call: This type of call refers to the requirements needed to begin a margin trade and can occur when an investor makes a transaction in a margin account without meeting the initial 50% minimum equity requirement. This is sometimes referred to as a Fed Call.

Minimum equity call: This is the lowest amount needed to open and maintain a margin account. This call - sometimes known as an exchange call - occurs when the account balance falls below $2,000 in equity. If you're classified as a pattern day trader, this requirement is $25,000.

How to avoid margin calls

You're not required to have a margin account, and you could easily avoid margin calls by only trading with cash. "The best way to avoid a margin call is to simply not use all your margin limit," says Farrington. Margin is not needed to achieve solid, consistent returns over time, but for those that choose to use it, here are a few things you can do to avoid a margin call:

• Keep cash on hand. One of the easiest ways to address a margin call is by adding cash to the account. However, if you do not keep enough cash on hand, this may be difficult.
• Stop loss orders. Entering a stop loss order can help limit losses and, depending on the volatility that day, it could prevent the stock from falling far enough to trigger a margin call.
• Stay informed. It is a best practice not to check on your investing account on a daily basis; however, this changes with a margin account due to the higher levels of risk. Investors may want to consider adding alerts should the price fall within a certain range.
• Use your margin limits wisely. Just because you're given the ability to take out a large margin loan doesn't mean that you have to. If you're using margin, consider using less than the maximum amount - this would give you a larger share of equity and a bigger cushion to avoid a margin call.

The financial takeaway

Using margin in an investing account can help increase gains, but it can also magnify losses. It's important to make sure you're properly managing your risk. "There are really few reasons to use margin," adds Farrington. "It should only be used by experienced investors who have a specific plan and purpose for doing it. Maybe you're investing today while waiting for that ACH deposit next week. Or maybe you're executing a certain options strategy. But you need to have a specific plan."