Margin Calls Explained: What They Are and How to Avoid Them
For many Australian investors, margin loans can be an effective way to increase investment potential and build wealth. However, they come with risks, particularly the dreaded margin call. This comprehensive guide will explain what margin calls are, why they occur, and most importantly, how to avoid them.
What is a Margin Call?
A margin call occurs when the value of securities in an investor’s margin account falls below the lender’s required level. In Australia, this is known as the loan-to-value ratio (LVR). When this happens, the lender demands that the investor deposit additional funds or securities into the account to bring it back up to the minimum value, or maintenance margin.
For example, CommSec defines a margin call as occurring when “your Current LVR exceeds your Base LVR”. The Current LVR is your loan amount divided by the value of your accepted investments, expressed as a percentage, while the Base LVR is the maximum LVR allowed on your account.
Why Do Margin Calls Happen?
Margin calls typically occur due to one or more of the following reasons:
- Market Volatility: A significant drop in the value of the securities held in the margin account can trigger a margin call.
- Changes in Lender Policies: Lenders may adjust their LVR requirements, potentially leading to a margin call even if market values haven’t changed.
- Concentration Risk: Having a portfolio heavily weighted towards a single stock or sector can increase the risk of a margin call if that particular investment underperforms.
- Interest Rate Increases: As noted by Westpac, an “increase in borrowing costs, i.e. interest rate increases” can contribute to margin call risk.
The Consequences of a Margin Call
If you receive a margin call, you typically have three options:
- Deposit additional funds into your account
- Deposit additional approved securities as collateral
- Sell some of your existing investments to reduce the loan balance
Failure to meet a margin call can result in the lender selling your securities without your consent to bring the account back to the required LVR. This forced selling can lead to realised losses and potential tax implications.
Strategies to Avoid Margin Calls
- Maintain a Conservative LVR
One of the most effective ways to avoid margin calls is to maintain a conservative LVR. BT Professional suggests, “Don’t borrow the maximum amount”. By keeping your LVR well below the maximum allowed, you create a buffer against market fluctuations.
- Diversify Your Portfolio
Diversification is key to managing risk. As BT Professional advises, “Diversity investments to help reduce volatility”. A well-diversified portfolio is less likely to experience dramatic swings that could trigger a margin call.
- Monitor Your Investments Regularly
Stay informed about your investments and market conditions. CommSec recommends that you “regularly monitor your portfolio to ensure you’re aware of any changes that may affect your margin loan”.
- Maintain a Cash Reserve
Keep a cash reserve that you can quickly access if needed. As Fidelity Investments suggests, “Leave a considerable cash cushion in your account that protects you from a sudden drop in the value of your loan collateral”.
- Use Stop-Loss Orders
Consider using stop-loss orders to automatically sell securities if they fall below a certain price. This can help limit losses and prevent your LVR from rising too high.
- Reinvest Dividends
BT Professional recommends to “Reinvest income produced from underlying investments to reduce the LVR”. This strategy can help maintain or even improve your LVR over time.
- Understand Your Loan Agreement
Familiarise yourself with the terms of your margin loan, including the maximum LVR, the margin call process, and any buffer your lender might offer. For instance, Fidelity notes that “Some lenders offer a ‘buffer’ on their margin loans. This means the lender won’t issue a margin call until the LVR exceeds the maximum LVR by a specified percentage”.
- Consider Making Regular Interest Payments
Instead of capitalising interest, which increases your loan balance over time, consider making regular interest payments. As BT Professional suggests, “Make regular interest payments rather than capitalising the interest”.
What to Do If You Receive a Margin Call
If despite your best efforts you receive a margin call, it’s crucial to act quickly. Most Australian lenders require margin calls to be addressed within 24 hours.
- Don’t Panic: While a margin call is serious, panicking can lead to poor decision-making.
- Assess Your Options: Quickly evaluate whether you can deposit additional funds, add more securities as collateral, or if you need to sell some investments.
- Communicate with Your Lender: If you’re having difficulty meeting the margin call, contact your lender immediately. They may be able to offer alternatives or extensions in some cases.
- Learn from the Experience: After addressing the margin call, review what led to the situation and adjust your investment strategy accordingly.
Margin loans can be a powerful tool for Australian investors when used responsibly. However, the risk of margin calls underscores the importance of careful planning and risk management. By maintaining a conservative LVR, diversifying your portfolio, regularly monitoring your investments, and keeping a cash reserve, you can significantly reduce the risk of facing a margin call.
Remember, while these strategies can help mitigate risk, margin lending still carries inherent risks. Always ensure you fully understand the terms of your margin loan and consider seeking advice from a qualified financial professional before engaging in margin lending.
Investing in the stock market involves risks, including the loss of principal. Margin lending can magnify both gains and losses. This article is for informational purposes only and does not constitute financial advice. Always conduct your own research and consider your individual circumstances before making investment decisions.