The Dreaded Margin Call
Our focus in this section is the how to maintain a margin account. In volatile markets, prices can fall very quickly. If the overall available margin (the cumulative loan value of all securities minus what you owe the brokerage) in your account falls below zero, the brokerage will issue a "margin call ". A margin call forces the investor to either liquidate his/her position in the stock or add more cash to the account.
Here's how it works. Let's say you purchase $20,000 worth of securities with a 70% loan value by borrowing $10,000 from your brokerage and paying $10,000 yourself. Your remaining available margin is therefore $4,000 ($20,000 x 70% - $10,000). If the market value of the securities drops to $18,000, the margin in your account falls to $2,600 ($18,000 x 70% - $10,000 = $2,600). Thus, you're fine in this situation.
Now let's assume that the value of the securities drops to $12,000. Your new margin would be –$1,600; you would be "under margin by $1,600 ($12,000 x 70% - $10,000). As a result, the brokerage may issue you a margin call.
If for any reason you do not meet a margin call, the brokerage has the right to sell your securities to increase your account margin until it becomes positive. Even scarier is the fact that your broker may not be required to consult you before selling! Under most margin agreements, a firm can sell your securities without waiting for you to meet the margin call. You can't even control which stock is sold to cover the margin call.
Because of this, it is imperative that you properly maintain your margin account and read your brokerage's margin agreement very carefully before investing. This agreement explains the terms and conditions of the margin account, including: how interest is calculated; your responsibilities for repaying the loan; and how the securities you purchase serve as collateral for the loan.