What happens when stocks hit the stop-loss? The chain reaction of margin calls and a practical guide to avoiding pitfalls

What Exactly Does a Margin Call Cause in the Stock Market

When it comes to financing to buy stocks, many people’s first reaction is “high risk.” But what actually happens when a stock hits a margin call? This is the real issue investors need to understand.

The Bill Hwang incident in March 2021 provided the market with a vivid lesson. This hedge fund manager lost $20 billion in just 48 hours, becoming the fastest loss in Wall Street history. His story is not just a failure case; it also serves as a warning about how margin calls can trigger chain reactions of market crashes.

The Essence of a Margin Call: Why Forced Liquidation Occurs

The logic behind margin trading is quite simple. Suppose you are bullish on a stock but lack sufficient funds; you can borrow money from a broker to increase your holdings. For example, if Apple stock is $150 per share and you only have $50, the broker can lend you $100 to buy the stock.

The benefit of this is that if the stock price rises to $160, your return will be much higher than the stock’s percentage increase. But the flip side is that if the stock price falls, your losses are magnified.

As the stock price continues to decline, brokers start worrying about recovering their principal. They set a safeguard— the maintenance margin ratio. For Taiwan stocks, the initial margin requirement is usually 167%. When the ratio drops below 130%, brokers will require investors to top up their margin. If investors lack sufficient funds to meet this margin call, the broker will sell off their holdings directly, which is called a “forced liquidation.” From the investor’s perspective, this is a “margin call” or “爆倉” (blowout).

What Happens During a Margin Call: Overly Oversold Stocks

When a margin call occurs, stock prices often exhibit a shocking phenomenon—overselling.

Retail investors might hesitate when they see prices drop, but brokers won’t. They just want to recover their money, so they will sell aggressively to close positions, not at high prices. The result is a sharp decline in stock prices, triggering more margin calls from other investors, leading to a new wave of margin liquidations.

Looking at Bill Hwang’s case, he held a large number of stocks. When brokers forced a liquidation, there weren’t enough buyers in the market to absorb the sell-off. As a result, some of his holdings were dumped relentlessly, which also affected his other seemingly stable stocks, causing margin shortfalls across his portfolio. Ultimately, his entire investment was wiped out in a short period.

Changes in Capital Structure and Long-term Effects After a Margin Call

How does a margin call further manifest? The answer is that the capital structure becomes chaotic.

Originally, the stock’s ownership might be held by management and long-term investors (like pension funds and insurance companies), creating a relatively stable situation. But after forced liquidation, the stocks are dumped into the hands of many retail investors. Retail investors tend to be short-sighted, buying and selling frequently with small fluctuations, which further scares away large institutional investors.

As a result, after a margin call, this stock is difficult to recover quickly unless the company releases significant positive news to attract new capital.

The Correct Approach to Margin Investing

Although margin trading carries high risks, using it wisely can improve capital efficiency. The key points are:

Choose the Right Stocks: Focus on stocks with high liquidity, i.e., companies with large market capitalization. Small-cap stocks are more vulnerable to sharp swings if large investors hit a margin call, and ordinary investors can get caught in the crossfire.

Calculate Costs Carefully: Margin involves interest payments, so it’s important to do the math. If the annual dividend income from the stock is roughly equal to the margin interest cost, then there’s no real investment advantage.

Timing Is Key: When the stock price reaches a resistance zone and starts consolidating, it’s time to consider taking profits. During consolidation, interest still accrues, which can be a loss. Similarly, if the stock breaks support levels and rebounds are unlikely in the short term, it’s better to cut losses rather than hold on stubbornly.

Use Dollar-Cost Averaging: If you are optimistic about a company but have limited funds, you can use margin to buy in stages. Even if the stock price continues to fall, you still have ammunition to buy more at lower prices.

Conclusion

Leverage is a double-edged sword; it can accelerate wealth accumulation but also speed up capital evaporation. Margin buying does carry the risk of margin calls and blowouts, and what happens during a margin call depends on how well you understand the market.

Doing thorough research and operating with discipline are the only long-term winning strategies in the stock market. Always recognize the risks before investing to avoid falling into unknown dangers.