Generally, newcomers in the trading scene want to focus on various other details of trading, such as chart patterns and technical indicators. They often overlook important elements such as margin levels, free margin, equity, margin requirements and margin ratio. All the above words are related to one of the most important aspects of forex trading, margin trading.
Before we discuss what a margin call is, we must first see what margin stands for in forex trading.
Understanding Margin
In the simplest words, margin is the amount you essentially need to place a trade and maintain a position in leveraged forex trading. Rather than a security cost, margin is more like a security deposit that the broker holds to open the trader’s position. By using margin you can increase your exposure, managing larger amounts of trades with relatively small capital.
For instance, if a broker offers a leverage of 30:1, it means the margin is 3.3%. You can trade $100,000 with just $3000 upfront as a result. Margin level refers to the amount you have left to open positions further. When this level drops to 100% you will not be able to open any new trades. If it drops below 100%, the position cannot be sustained by the account and is automatically closed. This mechanism is known as Margin Call which we will discuss below.
What is a Margin Call?
A Margin Call refers to a specific action by the broker where it closes the trader’s position if the trading account’s margin level falls below the required minimum level set by them. When this happens, the broker notifies the trader to deposit more money to meet the minimum margin requirement set by them.
So for every trade done in a trading account, all brokers reserve a corresponding margin to keep the trade floating. As your margin level drops below 100%, you will get notified by the broker that your account is no longer big enough to sustain open positions. You can either add more funds at this stage or close existing positions to free up margin.
How does a Margin Call work? ( Examples)
To understand how a margin call works, let's look at an example. Suppose a trader has a trading account balance of $5000 and wants to open a short position on USD/JPY for 1 lot. The required margin set by the broker is 3% which means it deducts $3000 from your balance as margin. In this case, the remaining $2000 is called the free margin.
The trader sells one lot of the USD/JPY currency pair with the expectation that the price will go down. However, the price of the pair starts to go up. This results in a $2000 loss for the trader, who now has $3000 left as available equity. A broker will probably send the trader a margin call at this point, either asking to liquidate the trade or refund their account.
Differentiating between Margin Call and Margin Call level
Many traders tend to get confused between two similar terms: “ Margin Call” and “Margin Call Level”. We have already discussed what a margin call is. Differentiating the two terms will help traders clear doubts along the way.
- Whereas the margin call is an event, the margin call level is a threshold that the broker sets after which a margin call is triggered. The margin level is expressed as a certain percentage such as 90%, 100% and so on.
- Thus, we can consider margin level as temperature, which can vary while the margin call is a specific temperature.
To better understand this, let's look at the following example.
Suppose the broker you're working with has set the margin call level at 100%, which is also the point at which the broker will send the trader a notification. You will not be able to open any new positions when your margin level reaches 100%. You can, however, close existing positions. So a margin call of 100% indicates that the trader’s equity is lower or equal to his/her used margin. The main reason why this happens is due to the trader keeping open positions whose floating losses build up.
Suppose you have $1000 in your account and want to open a 1 mini lot position in USD/CHF. The required margin will be the same as the used margin in this case since you only have one position open. Both of the margins are at $200. If the trader suffers a loss of 800 pips, it can easily amount to a floating loss of $800. When this happens, the trader’s equity becomes $200. Your margin level reaches 100% as a result and you will be unable to open any new positions unless you fund your account or the market reverses back in their favour.
Reasons why Margin Calls are triggered
In the simplest terms, when a trader doesn’t have any usable or free margin available, a margin call gets triggered. This usually happens when you dedicate a large portion of your equity to the used margin, leaving very little space for the account to take in losses. Some of the most common reasons for receiving a margin call are as follows.
- Usable margin gets used up if you stubbornly hold on to a losing trade.
- Over leveraging your account can have disastrous consequences.
- You can over-trade with too little usable margin if you use an underfunded account.
- Trading without using stops increases the likelihood of receiving a margin call.
Avoiding Margin Calls
When trading with leverage, a trader always faces the risk of receiving a margin call. The only way to avoid this is by observing stringent money management rules. Money and risk management are the pillars of forex trading and no one can guarantee that price won't move against the open trade even when forecasts are favourable. Here are some tips for traders who are struggling with margin calls.
- You must consider adding stop losses to all of your trades. In the above example, you will receive a margin call if you trade without a stop order and the USD/JPY decrease to a point. A stop-loss order acts like a stop order sent to the broker which gets triggered when the price moves against your trade. For instance, when trading (long) one mini lot of USD/JPY at 110.50, set your stop-loss at 109.5. So if the pair falls to this value, the stop loss closes your position for a limited loss of 100 pips or 100 USD. You should set the level of your stop-loss order according to the market requirements and the strategy you are using.
- As lots can change for each position, always calculate the lot you will enter a trade with. This should be based on the size of the stop-loss order in pips as well as on the risk percentage per single trade.
- The maximum risk per trade should not ideally exceed 2% of the trader’s account balance.
- You should always make sure that the margin level is greater than the margin call level. For instance, if the margin call is triggered at a margin level of 100%, the margin should be over 300 %.
- Never misjudge price movement and open a huge short position. This type of unplanned, arrogant and overconfident trading increases your chances of facing a margin call. To get around this, scale in your position. For example, trade with 1 mini lot instead of starting with 4 mini lots from the beginning and add to your position gradually. Thus scaling in positions using different stop loss levels can spread out and mitigate losses, lowering the chances of receiving a margin call.
- Holding positions overnight can get risky for new or smaller traders. Currency pairs can gap down on unexpected news and the use of leverage will further amplify your losses. Thus, you should focus on margin trading only for intra-day activities. Reduce your position size until you are not using margin if you intend to hold a position overnight.
- Stop losses can cut some or all of a trader’s losses before they trigger a margin call. It allows them to dictate the terms by which they maintain their equity margin in their account, which is better than leaving it up to the broker. Setting up a set of stop orders for small portions can ensure that the trader’s account is always meeting the maintenance margin.
- Stop losses can cut some or all of a trader’s losses before they trigger a margin call. It allows them to dictate the terms by which they maintain their equity margin in their account, which is better than leaving it up to the broker. Setting up a set of stop orders for small portions can ensure that the trader’s account is always meeting the maintenance margin.
Conclusion
Always remember that the broker isn’t liable to engage with you in anyway before closing trading positions. Almost all brokers include the right to close trades due to a margin call as part of their service agreement.