Margin Calls: What They Are, and Why Elon Musk Should Care

You’ve likely heard of margin before — a fast way to access leverage on your portfolio. But if you’re considering using margin to power-up your trades, you’d better read the fine print. Or better yet, consider using option strategies with defined-risk to provide higher leverage — without the danger of receiving a margin call.

Defining the margin call

Margin calls have become somewhat of a meme in the finance world. But what are they? How do they happen? And what effects do they cause on the market? 

First, let’s define margin. In the stock world, margin is essentially a loan given by a broker that you can use to purchase (or short) a financial instrument. But if you’re thinking about taking out margin to add leverage to your portfolio, you’d better read the fine print. 

Because every margin loan comes with a margin requirement — that’s the amount of collateral that you must keep in the account in order to continue accessing your margin loan. If the value of your account falls below the margin requirement, you will receive a margin call. 

If you receive a margin call, you must either add additional value to the account in question, or sell securities in order to make up the difference. Don’t want to sell your securities? No worries! Your broker will do it for you. 

The problem with using margin

The issues arise when you become overleveraged in margin securities. For instance, if you were to use margin to short a stock, and that stock rose exponentially (*ahem*, $GME), you could be putting yourself at an undefined level of risk. 

With your account value quickly depleting, even at risk of going negative, your broker would act: closing your positions for a loss at whatever the market price was. This can create a snowball effect that drives the market further in the direction opposite your position, called a squeeze. 

Melvin Capital

Famously, this is exactly what happened to Melvin Capital in January of 2021. Once a multi-billion dollar hedge fund with positions spread across the market, Melvin Capital was brought to its knees by a powerful margin call which drove the stock price of Gamestop higher by more than 2000%. 

The implications weren’t limited to Gamestop’s stock price. In order to fulfill the margin requirement, the firm had to quickly liquidate billions of dollars worth of long equity positions, helping to spur a market-wide drawdown, and proving that squeezes aren’t just for short positions. 

As for Melvin Capital? They’re still suffering from the effects, much to the chagrin of Gamestop holders. Just this week, more than a year after the events described above, Melvin Capital CEO Gabe Plotkin conceded to clients that they would likely not be made whole on their investments. Melvin is reportedly considering unwinding the fund in its entirety and rebranding due to the fallout. 

Archegos Capital Management

Melvin Capital wouldn’t be the only firm to receive a market-shaking margin call in 2021. Just two months later, in March of the same year, Bill Hwang’s fund Archegos would suffer the same fate. 

While Hwang has become somewhat of a meme himself in the market world, likened to the sort of traders who risk it all in the backchannels of r/wallstreetbets, he was a competent investor. 

Over a 20-year period (2001-2021), Bill Hwang turned $25 million dollars into more than $22 billion dollars, using margin to create leveraged returns on stocks he owned through his fund, Archegos. Archegos was a multi-billion dollar fund with core holdings in Viacom CBS ($VIAC), Farfetched ($FETCH), Discovery ($DISC), and Baidu ($BIDU). One look at any of those charts, and you know exactly what happened next.

In March of 2021, Archegos’ core holdings began to decline, setting in motion a massive margin call for Bill Hwang’s fund. The result: Archegos was forced to quickly liquidate its positions market-wide, shaking the entire stock market, and particularly Archegos’ core holdings — all four of which have yet to recover their losses. 

Bill Hwang would go on to lose $20 billion dollars in just two days, and Archegos Capital Management disbanded only a few days after that. The pain didn’t stop there… Just today, more than a year later, Bill Hwang was arrested on fraud charges for the events leading up to his infamous margin call. 

Why do we note these two massive downfalls? Because even the mightiest and most competent investors, with 20 year winning streaks and thousands of clients, can lose it all with just one bad trade. Even billionaires are not immune to the margin call.

Elon Musk’s big bet

That brings us to Elon Musk’s recent Twitter acquisition. You may not know this, but the richest man in the world is actually relatively cash-poor. Elon typically pays the bills with loans taken out against his Tesla holdings, not with his own cash. 

According to Reuters, before the Twitter acquisition Elon had already borrowed $88 billion against his Tesla holdings. The financing for his most recent purchase will push that figure upwards of $150 billion. 

As we discussed above, all margin loans come with a margin requirement. In this case, Musk borrowed $12.5 billion USD, and in return had to pledge $62.5 billion in Tesla ($TSLA) shares. The catch: if Tesla’s stock price falls below $570 (about 37% below its current share price of $902), Elon Musk will receive a margin call. 

It goes without saying that Musk is a man, not a hedge fund, and so the implications of a margin call here are Tesla-specific. But that doesn’t mean there couldn’t be market-wide implications. 

As CNBC’s Brian Sullivan has said, “Tesla isn’t just important to the market, it is the market.” That was in relation to all of the hedge fund option strategies that are directly tied to Tesla equity. 

The implications of Musk receiving a margin call, being forced to liquidate a large swath of his Tesla holdings and dragging the price down with it? Cascading liquidations across the market for any institution using high margin to fund their Tesla equity positions. 

The bottom line

Don’t be scared, just be safe. This isn’t meant to shake you, Elon, or anyone else out of their holdings. Tesla stock may come out unscathed, never returning to its $570 share price. But the lessons of prior margin calls and the risks that they create are very real. 

If you’re interested in taking on leverage, there is a much safer way than using margin: options. Specifically, by using defined-risk option strategies. Defined risk means that there is a finite amount of money that you can lose entering a position, and it’s declared up front. Whether it’s a long call or put, or one of the many advanced options spreads, you know what the risk is: the price you paid. The same can’t be said of margin, as we’ve covered in detail above! 

The power of options goes beyond the ability to lever-up your trades — options actually allow a smart trader to reduce their risk. For instance, rather than buying 80 shares of a stock, you could simulate that ownership and price movement with an 80 delta call option! Depending on the expiration date and the implied volatility, you’d be risking somewhere in the neighborhood of 10-15% the cost of buying all 80 of those shares, without losing access to the upside! 

Compare that to the cost and risk associated with using margin to get 2:1 leverage on the same stock! Higher cost (50%), less leverage, and the added risk of a margin call if you’re directionally wrong! Want to learn more about defined-risk strategies? Discover how to master the most powerful option maneuvers that professionals use to leverage their portfolio without risking a margin call in this free guide.