Missing out on a Margin Call or not knowing what to do when you get a call can lead to the automatic closure of all of your open positions in the market. As the positions get closed, your losses can get amplified unexpectedly. In this article, we discuss everything about Margin Calls and how to avoid its risks.
What is a Margin Call?
A Margin Call is an alert that the forex broking house sends to the trader to let them know that the funds in their account are now less than the minimum amount that is needed to keep a forex position open. Failing to add more funds back in the next two to five days can lead to the automatic closure of all the open positions immediately.
A Margin is a fixed percentage of an investment that a trader must have in their account at all times to continue trading with Margin.
How to calculate Margin Calls
Let us suppose that you open a Margin account with $20,000 in the account, half of which is borrowed from the broker, and the other half is your own funds. The Margin requirement is 30%, denoting that at all points in time, your account must always have 30% of $20,000 = $6000. Now, if you wish to trade USD/EUR and buy 20000 units of it at the rate of 1, a drop in the investment value by 40% would lead to the total amount falling to $12000. The new Margin requirement would be 30%*$12000 = $3600.
At this point, the amount you borrowed from your broking house will remain the same, whereas your own funds will drop to $2000, becoming lower than the 30% Margin requirement.
You will receive a Margin call unless and until you deposit $1600 in your account by initiating a process or liquidating a part of your positions.
- When you directly deposit funds to the trading account to reach the Margin requirement, the amount needs to be equal to the required Margin Call’s amount
- When you liquidate currency pair positions to cover the Margin call, the amount of currency pairs you sell is equal to the Margin amount divided by the minimum maintenance requirement
In our example, the total worth of currency pairs you will have to sell to cover the Margin is = $1600/0.3 = $5333.34
What are the causes of a Margin Call?
Margin Calls are caused when there are no usable funds within the required Margin limit anymore. Repetitive losses can lead to a reduction in the Margin. In most cases, whenever a trader invests more than the usable Margin, there is very little scope to manage risk effectively since you can end up losing much more money than you initially invested.
- When the account is underfunded, you are forced to over trade with little usable Margin that leads to Margin Calls
- When you hold onto a losing trade or falling currency pair for too long, it depletes your usable Margin overtime, amplifying the chances of a Margin Call
- When an account is over-leveraged, it can get challenging to return back the principal and interest amount which can results in a spiral of losses — again depleting the Margin and leading to Margin Calls
- When you trade a currency pair without stop-loss and limit orders, aggressive price moves in the opposite direction can lead to heavy losses, which decreases the Margin and causes a Margin Call
What are the consequences of a Margin Call?
As soon as a trader receives a Margin Call, they are closed out of their positions for the time being. Here are the consequences of a margin call:
- All positions can be sold without the trader’s permission if they fail to add funds in the account to match the Margin
- The broking house can also charge fees, commissions and interests against the unpaid amount
- The broking house becomes sole decider to choose which positions need to be liquidated, and no approval is needed from the trader
- The broking house may not let the trader borrow on Margin again unless and until they meet the Margin requirement
How to avoid Margin Calls?
1. Avoid over-leveraging
Leverage involves using borrowed funds to expand one’s trading exposure. The more leverage you use in your account, the less Margin is available to absorb possible losses. Over-leveraged positions deplete the funds very quickly through multiplied losses.
2. Keep Margin free
You should always have a considerable amount of Margin in your account that allows you to trade greater positions. Free Margin is calculated by subtracting the total Margin of the open positions from the total equity. The higher the free Margin you have, the lesser are the chances of the Margin depleting to the extent of receiving a Margin Call.
3. Apply risk management strategies
Stop loss and limit orders can be applied to minimize risk and avoid Margin Calls while trading. When you open trade positions and fix the stops, you ensure that if a position drops over a certain point, you will get out of the trade by only absorbing as much loss as your risk appetite allows.
4. Trade small as you begin
If you are a beginner trader and want to avoid Margin Calls at all costs, it is recommended to start small. Take smaller positions in the market and add to them slowly. This will help you maintain the equity to usable Margin ratio.
Avoid Margin Calls to protect your positions
It is imperative that you always maintain the required Margin in your trading account to avoid Margin Calls.