What is a liquidation margin?
Liquidation margin is the value of all positions in a margin account. These can include long and short positions.
Since margin accounts are subject to margin calls, the current liquidation margin is an important concern for margin traders and their brokers. If the liquidation margin becomes insufficient to support the trader’s positions, the broker can liquidate these positions to reduce his risk.
KEY POINTS TO REMEMBER
- A liquidation margin is the current value of a margin account based on its cash deposits and the most recent market value of its open positions.
- If traders let their liquidation margins become too low, they may face margin calls from their brokers.
- Traders can increase their liquidation margins by depositing additional cash in their accounts. Other forms of guarantees may also be used.
Understanding the liquidation margins
Margin trading is the practice of borrowing money from a broker to execute leveraged transactions. When buying securities, this leveraged transaction involves borrowing money from the broker and using it to buy securities. In short sales, leveraged transactions consist of borrowing the securities themselves from the broker’s inventory. The leveraged short seller then sells these securities and seeks to buy them back at a lower price in the future.
When using the margin, a trader must ensure that the total value of the margin account does not fall below a certain level. The value of the account, which is based on market prices, is called the liquidation margin.
To illustrate, consider a scenario where a trader makes a series of leveraged stock purchases. Suppose these purchases start to generate losses. Then the liquidation margin of the account will start to decrease. If the decline continues, it will eventually reach the point where the broker has the right to launch a margin call.
A margin call would effectively force the trader to provide additional guarantees for the account in order to reduce his level of risk. Generally, this guarantee is to deposit more money in the brokerage account. This cash is part of the liquidation margin, raising the margin level above the required threshold.
Types of Liquidation Margins
If an investor or trader holds a long position, the liquidation margin is equal to what the investor or trader would keep if the position was closed. If a trader has a short position, the liquidation margin is equal to what the trader should buy the security.
Example of liquidation margin
Sarah is a margin trader who has invested all of her $ 10,000 in a single stock using 100% leverage. For simplicity’s sake, assume that Sarah has already paid the required margin interest. It now controls $ 20,000 in shares. However, the initial liquidation margin is only $ 10,000. $ 10,000 is what Sarah would receive if the account was closed.
Suppose Sarah’s stock performed poorly and fell 25%. Since Sarah initially used 2: 1 leverage, this means that she lost 50% of her original investment. Sarah’s account now has a liquidation margin of only $ 5,000, but she orders $ 15,000 of stock. At this point, a more conservative brokerage might worry and make a margin call.