Computing the Margin Call Price
The price at which a margin call is made can be found using the expression:
$$\displaystyle MM=\frac{E_{i}+P_{c}-P_{i}}{P_{c}}$$
_where_
$$\displaystyle MM = \text{Maintenance Margin}$$
$$\displaystyle E_{i} = \text{Initial Equity}$$
$$\displaystyle P_{c} = \text{Current Price}$$
$$\displaystyle P_{i} = \text{Initial Price}$$
Suppose you have just purchased shares in a company that sells party supplies. You bought the stock at USD 30 and financed 60% of the purchase using a margin loan that requires a 30% maintenance margin. At what price will your broker contact you for a margin call, taking some of the life out of your party?
Incorrect.
You got it!
The margin call price is found by substituting the parameters of your trade into the earlier expression:
$$\displaystyle MM = \frac{E_{i} + P_{c} - P_{i}}{P_{c}}$$
$$\displaystyle 30 \% =\frac{\text{USD}\ 12+\text{USD}\ 25.71-\text{USD}\ 30}{\text{USD}\ 25.71}$$
The right side of the equation is 29.99%, so USD 25.71 is indeed the price at which the maintenance margin falls below 30%. For an explicit solution of $$P_c$$, some algebra will take you to:
$$\displaystyle P_c = \frac{E_i - P_i}{MM - 1} = \frac{\text{USD}\ 12 - \text{USD}\ 30}{0.30 - 1} \approx \text{USD}\ 25.71$$
Had your initial equity been 60%, and not 40%, the margin call would have been made at USD 17.14:
$$\displaystyle 30 \% =\frac{\text{USD}\ 18+\text{USD}\ 17.14- \text{USD}\ 30}{\text{USD}\ 17.14}$$
The right side of this equation is 29.99%, so USD 17.14 would be the margin call price under those conditions.
If you were to describe the use of a margin loan to a friend, how might you do so?
That's right!
Incorrect.
To summarize:
[[summary]]
A trader that buys a security on margin stands to lose more than his equity in the trade if the price moves against him. If the margin loan is not repaid, the broker that lent the money can lose quite a bit of money.
Brokers require traders that buy on margin to maintain a __maintenance margin__ for their trades. If the trader's equity drops below this amount, he will get a __margin call__ to contribute more equity. If he does not meet the margin call, the position will be closed to ensure the loan is repaid.
When you use a margin loan to purchase a security, you are increasing, not reducing, your potential investment returns through the use of leverage. The drawback to this is that your broker will require a minimum amount of equity be maintained on the position, limiting how much a stock's price can drop before a margin call is made.
The more you borrow, the less slack you have with respect to adverse price movements in the security.
USD 17.14
USD 25.71
The more money borrowed, the lower the potential return and the more a stock's price can fall before a margin call is received
The more money borrowed, the higher the potential return but the less a stock's price can fall before a margin call is received
Continue
Continue
Continue
Continue
