What is a margin call? The risks of forced settlement in financing transactions and their specific impacts.

In March 2021, Bill Hwang became the fastest person in modern history to incur massive losses. He lost 20 billion Dollars in just two days, shocking Wall Street. The market only said that he had "blown up" his account, meaning that his holdings were forcibly settled by the platform.

But in reality, what is a liquidation? What is a margin call? I'll explain in detail!

What is a Margin Call?

A margin call is a concept commonly seen in the stock market and futures trading, and simply put, it refers to a forced settlement due to insufficient margin.

I will explain why forced Settlement occurs by giving an example.

If you have high hopes for a company's stock but do not have sufficient funds, or if you want to hold many shares with strong confidence in its future, you will use "margin" to buy stocks. Just like taking out a loan from a bank when buying a house, in margin trading, you use part of your own funds and borrow the rest from a brokerage to purchase stocks.

For example, let's say you want to buy shares of Apple. Currently, one share costs 150 Dollar, and you only have 50 Dollar on hand. If the brokerage lends you 100 Dollar, you can purchase one share.

If Apple shares rise to 160 Dollar, you will sell the shares and repay the brokerage 100 Dollar plus interest of 0.5 Dollar, leaving you with a profit of 59.5 Dollar. In this case, you will achieve a profit of 19%, significantly exceeding the 6.7% increase in Apple’s stock price.

However, if Apple stock falls to 78 Dollar, the brokerage will require you to provide additional margin. This means they will ask for extra funds to guarantee the repayment. If you cannot pay that, the brokerage will forcibly sell your shares.

Taking the Taiwanese market as an example, in a normal lending transaction, investors provide 40% of the funds, while the securities company provides 60%. If the initial stock price is 100 Yuan, the Margin Maintenance Ratio at this point is 167%(100÷60). If the maintenance ratio falls below 130%, meaning the stock price drops to 78 Yuan, the securities company will require additional funds from the investor. This is called a "Margin Call." If the investor fails to pay the additional margin within the specified period, the securities company has the right to forcibly sell the investor's stocks. This act is referred to as Forced Settlement, and from the investor's perspective, it is called Margin Call or Liquidation.

The Impact of Margin Calls on Stock Prices

Impact 1: Margin calls further decrease stock prices.

General investors tend to carefully consider selling in order to avoid realizing losses during a stock price decline.

However, for brokerage firms, the recovery of loaned funds is the top priority. They do not consider selling at high prices for investors, but rather aim to liquidate quickly. As a result, when a certain stock experiences a significant decline and margin calls occur, the stock price usually drops to an extreme low, further triggering a chain reaction of margin calls that accelerates the decline in stock prices.

Therefore, investors holding long positions should avoid securities that carry the risk of margin calls, and investors shorting may be able to take advantage of this opportunity to make a profit.

Impact 2: After a margin call, the supply and demand for stocks becomes unstable.

Typically, corporate management and long-term investors (such as pension funds and insurance companies) are considered stable shareholders, but stocks that are dumped by brokers after a margin call often end up in the hands of many individual investors. Individual investors tend to pursue short-term profits and trade on small price fluctuations, causing large funds to avoid investing in those stocks. This situation can lead to continued stagnation in stock prices until the next major positive news emerges.

Therefore, it is better not to touch the assets after a margin call. There is a high possibility of a deep decline in a short period of time.

Let's return to the story of Bill Fan, the man who lost a fortune faster than anyone else in the world, introduced at the beginning of the article.

He was a hedge fund manager who selected promising companies and employed an investment strategy that involved using large amounts of leverage to amplify returns. In other words, he kept buying stocks on credit. With this method, he managed to increase his assets from 220 million dollars to 20 billion dollars in just 10 years, becoming a significant presence on Wall Street. But what high leverage fears the most is a black swan (an unpredictable large fluctuation).

In 2021, due to significant fluctuations in the stock market, his position faced considerable volatility. The brokerage firm enforced a forced Settlement of his stocks to avoid losses. Since the scale of his holdings was enormous, while an ordinary person would simply sell their stocks at the current market price when facing a margin call, in the case of Bill Fan, the amount held was too vast, and there weren't enough buyers in the market at the time of sale. This led to a sharp decline in stock prices, causing other investors to also be caught in a chain reaction of margin calls.

How to Effectively Utilize Lending Transactions?

Lending transactions may sound risky, but if utilized properly, they can allow for more efficient use of funds.

• If you are expecting a certain company but have limited funds and can only make a lump-sum purchase, you can benefit from the effect of dollar-cost averaging through financing. If the stock price rises after the purchase, you can enjoy profits, and if the stock price falls, you can make additional purchases with the remaining funds to lower your average acquisition cost.

• An important lesson we can learn from the case of Bill Fang is that when buying stocks with loans, one should choose stocks with sufficient liquidity, meaning those with a large market capitalization. Otherwise, if large shareholders face a margin call, there is a risk of significant fluctuations in stock prices.

• In lending transactions, it is necessary to pay interest to the brokerage firm, so the timing of investment and the selection of target stocks is particularly important. There are stocks with almost no price movement, and for such stocks, investment returns will mainly come from dividends. If the annual dividend and the cost of loan interest are almost the same, there is no point in investing.

• Stock prices may also move sideways between resistance and support lines. If purchased on margin, even if the stock price rises to the resistance line but cannot break through, it will remain sideways for a long time, and you will have to pay interest during that time. Therefore, it is recommended to lock in profits and sell if the price becomes sideways without breaking through the resistance line. Similarly, if the stock price falls below the support line, the likelihood of a quick recovery is low, so it is advisable to cut losses immediately.

Disciplined trading is the way to achieve long-term success in the stock market.

Conclusion

Leverage is a double-edged sword. When used effectively, it can expand profits and accelerate asset formation, but it also accelerates losses simultaneously. Margin trading is a high-risk strategy, but there are also risks of margin calls and liquidation.

Make sure to do thorough research before investing to avoid exposure to unknown risks!