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A trader can buy securities not only with their own money but also with funds provided by a broker, i.e., leverage. It increases both profitability and risks. When the risks go off the scale, a margin call occurs. To begin with, you need to know the definition of margin.
If, during margin trading, quotes go in the wrong direction, which is unexpected by the trader, they begin to suffer losses. Losses reduce the margin, and when it reaches a critical value, the trader receives a notification from the broker that it is necessary to deposit funds into the account. This notification is called a margin call.
The notification comes via the trading terminal or e-mail. At this stage, the broker simply warns the investor. A margin call can be received, among other things, during margin option trading.
A margin call can be caused by:
unfavorable price conditions, usually a sharp move in price;
a change upwards in the margin requirements of the exchange or the broker for any instruments in the portfolio.
If a margin call is just a warning that the trader might have problems, at stop out the broker will automatically close some or all positions previously opened by the trader. Suppose the broker does not forcibly close unprofitable positions. In that case, they may stay within the initial deposit amount, and the broker will have to cover this difference at his own expense.
There is a formula that can be used to calculate how much a stock has to fall before a margin call can occur:
Minimum account value = Margin loan / 1-Maintenance margin requirement
If the account's value or equity becomes equal to the margin requirement, a margin call occurs.
Here is a simple example to illustrate the essence of a margin call.
You have $1000 on your trading account and open a position with a required margin of $300. You can use the margin calculator to find out which required margin affects the position. After the purchase, your account will have the same $1,000, but $300 will be blocked, and you will not be able to buy other stocks with it. The difference between $1000 and $300 is called free margin. In this example, the free margin would be $700.
The amount of margin increases or decreases as profits or losses increase. You get access to margin only after you close a trade (for example, when you sell the stock you bought).
The critical value leading to the margin call is a percentage of the margin amount. Each broker has its own maintenance margin requirements, which can be 20-30%.
In our example, the trader has $1,000 in their account and opens a position using a $300 margin. A margin call will be triggered when the total margin in the account reaches a certain level. If the broker has set the maintenance margin requirement at 30%, then the margin call can be calculated as $300 × 30%. That is $90. If they have two $300 positions open, the margin call will come in at $180, and so on.
Please note that the margin call will come when the total margin on the account for all open positions reaches 30%! This means you should close your position and boost your trading knowledge with a forex education guide.
There are several ways to avoid a margin call:
Prepare for volatility and carefully forecast asset price movements before making a trade.
Set a personal trigger. Experienced traders never neglect setting stop-loss and take-profit as the market becomes increasingly volatile.
Monitor your account regularly, or put more money into your trading account than is needed for the transaction.
Use online tools, such as an online calculator. By entering the necessary data, you will receive information about your probable profits or losses.
It should be noted that receiving a margin call does not affect the trader's status and does not make them less trustworthy. It only serves as a notification that the point of no return is about to come and a decision should be made immediately.
There are several options after receiving the warning:
Fund your trading account. As the available funds increase, the margin level will increase, and the broker will remove its warning.
Close one or more losing positions. In this case, on the one hand, losses on closed trades will not increase. But on the other hand, the price can change.
Just wait and do nothing. If the price rebounds, you're a winner. You can at least minimize the losses if the price does not reverse but enters a correction. However, with a clear understanding of what to expect from the market, such a strategy is meaningful and risks ending in a stop-out.
As in any other case, margin trading involves some risks:
The amount of loss increases in case of an unsuccessful transaction;
If the liquid portfolio's value falls below the minimum margin, the broker may forcibly close the positions.
However, there are also advantages:
A larger amount of potential profit due to the opening of positions using borrowed funds;
Possibility to trade not only for price increases but also for price decreases using short deals.
In the case of a margin call, you need to eliminate the margin deficit as quickly as possible. Otherwise, the broker can remove the securities or other assets from your account. Sometimes, you are given several days to meet the margin call, but acting promptly is in your best interest.
To reduce the risks of margin trading, control your positions in the trading terminal, use stop-loss and independently monitor the margin level. Most importantly, try never to use credit funds to the maximum.
In the event of a sharp market decline, investors start selling shares to meet margin calls. In turn, the large number of sales leads to a drop in prices, and this leads to an increase in margin requirements. Thus a vicious circle is formed, the consequence of which is aggravation of market volatility.
Margin trading is a powerful tool designed to maximize profits at a low level of invested capital. However, there are other paths to guaranteed profits. It would help to use margin trading with caution because it also involves serious risks. To avoid the unpleasant moment of margin call, maintain control of all open positions and close them in time.