Let’s say that you pledge $30,000 of your own shares and borrow a further $70,000 from a margin lender and invest the entire amount, $100,000, into a portfolio of shares. Your LVR in this example is 70%.
If the value of the portfolio falls from $100,000 to $90,000, the LVR of 70% will be exceeded and a margin call will be triggered. To calculate the LVR, simply divide the loan amount, $70,000, by the total value of the portfolio, or $90,000, giving an LVR of 78%. Since an LVR of 78% exceeds the permissable LVR of 70%, we’ve entered margin call territory.
So what recourse do you have should you come face-to-face with a margin call? Investors have a couple of options: they can either lower the loan amount by injecting cash or more shares into their account or, alternatively, sell stock to get the LVR down. Should neither option be taken within 24 hours – and clearly this is what happened to Groves and his ABC Learning shares – the margin lender will take action on the investor’s behalf. The required number of shares will be sold off until the LVR is brought down to its original value.
Occasionally an investor may find themselves fair smack in margin call territory for reasons other than a slumping share price. Investors with margin loans over Allco, Centro and MFS experienced difficulties recently when leading margin lenders either removed these stocks from their approved list, or sharply lowered LVRs. Investors were made to swiftly meet the reduced LVR requirement by injecting cash or shares into the account or selling stock; in the case of stocks that were removed from the approved list altogether, the LVR was reduced to zero.
In many instances, investors without the cash on hand to inject into the account are forced to sell shares. In the worst-case scenario, an unlucky investor might be forced to sell up when the shares are wallowing at a low. (It’s worth considering the reason why a margin lender suddenly reduces a stock’s LVR, or takes the stock off the approved list altogether. The move might be a sign that the risks of investing in that particular stock have risen sharply. You might want to evaluate why this might be the case and how that impacts your investment strategy).
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When faced with a margin call it’s worth checking with your lender whether you simply need to reduce the buffer, back to say 3 or 4% over the LVR, or restore it to zero. Depending upon the size of your loan, the difference can be substantial; reducing the buffer back to zero means more shares must be sold (or more cash injected) to make up the shortfall.
In brief, the best medicine for staving off a margin call is to hold a diversified portfolio of stocks across myriad sectors, don’t borrow up to the maximum LVR on offer, reinvest your dividends rather than cashing them out and pay off the interest rather than capitalising it.