Gurshawn Jagpal

With the US equity markets at record highs, VIX tends to be lower. However, this usually entails margin building up beneath the surface. When markets are high, buying stocks on margin increases more as risk tolerance rises. Most investors and traders that I personally know will never buy stocks or any asset on margin (commodity futures, FX pairs, common equities, long call options, etc.) However, I believe that most participants in the markets should care about margin as when margin calls happen, asset prices drop as prime brokers call in the loans. This leads to a fire sale in asset prices and investors in the markets may watch their portfolios drop in value. Watching the evaporation of wealth may lead to fear for those long-term investors and could cause them to liquidate their assets. However, during these fire sale movements, investors and traders should remember that fundamentals aren’t at play. Mechanics are.

Usually, when the markets drop and VIX rapidly rises, I remind myself that the rapid decline in the markets isn’t because the world is ending but just investors rapidly selling due to margin calls. When the hedge fund Situational Awareness imploded, AI-linked names such as Bloom Energy, SanDisk, Micron, etc. went down rapidly. If one held those holdings, one may have panicked and could have sold their holdings in panic.  

Let’s imagine a situation where a hedge fund buys Mango AI Inc. stock at $40 per share. A total investment of $40,000. Initial margin is $20,000 (Regulation T requires initial margin of 50%).  The hedge fund borrowed from a prime broker. The broker put a maintenance margin requirement of 40% (Investments banks can choose their own maintenance margin requirements).  This means that if the stock falls 16.7%, the hedge fund will get a margin call. Here is my Model of a Margin-induced Sell-off:

1. Markets initially drop due to geopolitical tensions in the Middle East.
2. Since 2009, it’s been a popular strategy for many to constantly buy the dip in the markets. Those with margin hold onto their positions, hoping the positions will bounce back. Let’s say for our example, we are talking about Mango AI Inc.
3. Algorithms sense the stops or price levels for Mango AI Inc. can lead to margin calls (My theory).
4. Algorithms or other hedge funds, short Mango AI Inc. hoping to capitalize on a trend of prices going down (My theory).
5. Mango AI Inc. stock falls to the point where it leads to margin calls.
6. Margin calls cause Mango AI Inc. stock to fall 20% more.
7. Non-leveraged investors who hold Mango AI Inc. start to panic.
8. Hedge funds who shorted the stock, bought Mango AI Inc. stock.
9. The hedge funds who bought Mango AI Inc. waited until it recovered 25%. The hedge funds sold after it hits the pre-margin call price (My theory).

The example I talked about above is a very simplistic example. Some major hedge funds can get preferential treatment on leverage rules.

This is my theory, but I believe that algorithms can figure out how far prices can fall for margin calls to hit. I don’t use margin to invest. However, the reason for writing this article isn’t to predict a black swan event (where equity markets crash by over 50%, Great Depression levels). But to warn investors and traders to be ready for margin-induced sales when the S&P 500 eventually falls. It’s precaution for the future so people don’t sell their investments just because prices suddenly fall. It doesn’t make sense to sell if their investment thesis holds.

Working notes. I used AI only to clean grammar. The views are mine. Not investment, tax, or legal advice.