Textbook Margin Selling Example

When you buy on margin, the brokerage/clearing firm puts up as much as 50% of the purchase price of the stock. The customer, whether professional, such as a hedge fund, or retail investor pays interest on the borrowed funds and if everything goes well, takes profits on the purchase and pays back the margin loan. However, when the trade goes against the margin buyer, the broker/clearing firm, will inform the margin buyer that if they do not come up with sufficient funds, the broker/clearing firm will exercise its right to close the trade.

When the market experiences multiple down days in a row, it is a matter of time before some sort of margin selling will rear its head.

The past few weeks have been especially tough on margin buyers, and have provided several sessions of great examples of margin selling. Our first graph from yesterday (October 29th) shows that dramatic 338 point decline in the DJIA from 3 pm ET until just fifteen minutes prior to the close. Once the algos and high frequency traders exhausted the selling pressure, the rebound was sharp and deadly. The DJIA came back 263 points in that final 15 minutes.