There are two types of traders: those who learned about margin calls the hard way and are now setting stop losses and those who are still unaware of what a margin call is. If you are reading this guide, you most likely just received a margin call and are now trying to find out what happened with your trading capital. Yet we still hope that this is not the case, and you simply want to do your homework before you start trading with real funds.
In simple terms, a margin call is a request sent by a broker to have a trader deposit more funds, so the trader's position may remain open. If the trader's account no longer has the required amount of money to maintain his position, a broker may close the position on their behalf.
A margin call may happen only for the trades that are done with a margin, meaning when a trader opens positions that are larger than his disposable capital. Hence, the easiest way to avoid the margin call is simply by avoiding margin trading. Alternatively, setting a proper stop loss for every open trade will also eliminate the chances of being called on your margin.
“When you combine ignorance and leverage, you get some pretty interesting results.” — Warren Buffett
Let's dive deeper into the subject and understand the mechanics of the margin call as well as learn about two additional ways to avoid it.
A margin call occurs when a trader is informed by the broker that their market position is moving in an undesirable direction, and the trading balance has dropped below the level required for margin trading.
In this case, the trader is required to take immediate action by funding their account in order to maintain their margin level, and keep their market position alive. Otherwise, the broker is going to close this market position and realize the losses that were incurred already.
The name “margin call” originally comes from the way trading used to be done back in the day. When a trader’s usable margin depleted or dropped to a certain level, brokers used to call their clients by telephone to inform them of the situation. But as things developed and became automated, brokers can now use different channels to contact investors such as text messages, email, and even directly through trading platforms.
The margin requirement refers to the amount the trader needs to have in their margin account, expressed as a percentage. The margin requirement is set differently between brokerage firms, so you need to confirm it with your broker beforehand.
“Leverage has the potential to turn a reasonably good investment into disastrous gambling.” — Naved Abdali
These two terms are important for traders to understand. The initial margin is the amount of liquid capital that a trader needs to have in order to open a margin account, which enables them to use leverage for trading.
Most brokerage companies ask traders to have at least 50% of the security value, in order to ask for the rest of the amount to be funded by the broker using leverage. For example, if you are going to buy stock of X corporation that costs $100,000, the broker will ask you to have at least $50,000 equity before using leverage to purchase the full amount.
While the maintenance margin is the amount of money you need to have in your margin account when you have an open position. This maintenance margin is directly connected to the margin call and if you maintain this maintenance balance as required by the broker, you are not going to receive any margin calls.
Most brokers ask for a margin requirement of 25% of the security value, however, it can vary between brokerage firms. If your maintenance margin drops below the margin requirement you will receive a margin call, and the broker will ask you to add more funds to keep the maintenance margin as required.
Imagine you want to buy stock of X corporations, the value of this investment is $100,000, and you use $50,000 of your personal funds and $50,000 borrowed from the broker. Assume that the broker’s margin requirement is 30% of the investment.
Your equity as a percentage = (security market value - borrowed funds) / security market value
Your equity as a percentage = ($100,000 - $50,000) / ($100,000) = 50%
Your equity as a percentage against the amount borrowed from the broker is 50% which is higher than the margin requirement of 30%. In this case, you have enough money to keep the market position alive, and you are not going to receive a margin call.
Now, let’s assume the market moved in an unfavorable direction, and the value of the stock you purchased dropped to $70,000. Let’s calculate your new equity ratio.
Your equity as a percentage = ($70,000 - $50,000) / ($70,000) = 28.5%
Now, this is below the margin requirement of 30%, and you are going to receive a margin call from your broker telling you to add more funds to back the borrowed funds and to keep your account alive. Your new equity now amounts to $20,000: ($70,000 - $50,000).
The broker is going to calculate how much you need to add to your equity as follows:
(security value × the margin requirement (30%)) - current equity = deficit amount
($70,000 × 0.30) - $20,000 = $1,000
So as this calculation suggests, if you add $1,000 to your equity it will cover the margin call and keep your trading position alive.
In order to understand how the Forex margin call happens, let’s explain how leverage works, and what the correlation is between them.
Leverage is basically borrowing money from the broker to help you increase your trading balance. It allows you to open a market position worth $100,000 without you funding the whole amount. You may have only $10,000 and still be able to execute such a market order.
This way, you are exposed to higher-value trading opportunities, which can amplify your gains. But it can also be catastrophic and instead of big profits leave you with even bigger losses if the investment turns out to be unsuccessful.
The margin call occurs as a safeguard against your and the broker’s funds being lost. It calls for the trader to add enough money to balance the leverage ratio and to keep the broker’s money safe from the risk of losing the whole amount if the trade continues to go down.
This is more likely to happen when the trader uses a huge percentage of leverage compared to the amount funded by the trader. This way the trader’s money is very tiny when it comes to cushioning the price fluctuations. Therefore, any slight market movement will put the leverage position in danger, and obviously, the broker is not willing to keep up the market position by themselves.
When you receive a margin call, your broker will inform you how much time you have in order to cover this call. In most cases, the broker allows a period of 3 to 5 business days to cover your margin.
You can cover the margin by adding funds to your trading account, which will be added to that specific market position's equity. Alternatively, if you have any other market positions open, assets, or other securities under the same account, you can sell your security to gain some cash flow to add to your equity.
However, if you fail to resolve your margin call and the deadline given by the broker is over, your broker will sell any other security you have in the same account, or will close the current margin account and the trader will incur losses. Additionally, the trader will have to repay the broker if they have lost any of the borrowed funds due to the margin call.
Using a margin in trading has many benefits. However, a trader needs to know exactly how to approach each trade when using leverage, in order to avoid receiving a margin call. The following steps will help you to manage margin calls:
Generally, not all traders receive a margin call. It usually happens with those who open market positions in volatile markets and hold them for a long time. You are unlikely to lose money on a margin call if you trade moderately, meaning that you use moderate leverage, with a moderate contract size and in a moderately volatile market.
There are many Forex trading strategies that can help you to avoid getting a margin call. Scalpers and day traders do not receive margin calls while day trading. They keep their eyes on the trading platforms, observe the market movement, and can react before a margin call takes place.
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A margin call takes place when your trading position is losing and goes below the margin level. It mainly happens when traders borrow funds from brokers through leverage, and additional funds are required to back the broker’s funds from the risk of losing the market position.
When a trader receives a margin call, they are given a period of time to add funds to their equity. Traders can transfer money to their trading account, or liquidate some assets if they have any other securities under the same trading account.
The broker can call your market position off. They can sell your market position and burden you with the losses that resulted from the trade. Additionally, if the broker lost any money from the leverage, a trader is required to compensate the broker.
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