Margin calls are one of the most important and dangerous events in margin trading. Understanding what a margin call is, when it occurs, and how you should handle it is vital for traders who trade on borrowed funds.
This Blog
will explain how to handle margin calls and help you understand them.
Understanding Margin Trading Fundamentals
Before diving into margin calls, it’s important to have a basic understanding of margin trading.
What is Margin Trading?
Margin trading is a way to trade with larger amounts of money than you initially invested.
Leverage
It amplifies profits as well as losses. With 10:1, for example, you can trade $10,000 in assets with a $1,000 investment. Initial Margin (IM) is the amount you must deposit before opening a position with leverage.
Maintenance Margin (Meaningful Equity):
Minimum equity needed to maintain a margin position.
What is a margin call?
- You will receive a margin call when your margin account value falls below the minimum margin that your broker (maintenance) requires.
- What happens? Margin calls are triggered if your account equity falls due to losses and you do not meet your broker’s minimum maintenance margin requirement.
- Your broker wants you to deposit more money or sell some assets to restore the margin.
Margin Call: Key Terms
Equity
The total value of your assets minus the amount borrowed. Leverage is the ratio between your borrowed funds and equity.
Maintenance Margin (Measurement Margin)
This is the level your broker has set for you to maintain to avoid margin calls.
Liquidation level
If you don’t respond to the margin call, your broker will liquidate (sell) assets to recover losses.
Margin calls: How they Work
Here’s a step-by-step breakdown:
Initial Deposit
You begin with $5,000 and then borrow $5,000 more from your broker. Now you have $10,000 in your account to trade. Price Drop: If the asset you invested in falls in value, your equity will be reduced.
Trigger Point
Your broker will issue a margin call when your equity falls below your maintenance margin threshold ($2,500, for example). Action Required: Add more money to your account Sell assets to make up the shortfall in margin.
Example of Margin Call Scenario
Starting Scenario
Account balance: $10,000. (You invested $5,000 and borrowed $ 5,000 from your broker.
Leverage
2:1 (you can control assets worth $10,000 with $5,000 of your capital). Maintenance margin: 25%
Discounts on Products
Your portfolio is reduced to $7,000 by a 30% drop in value. Your equity: $7,000 (loan amount) – $5,000 = $2,000.
Maintenance margin required
25% of $7,500 = $1750. You’re still safe because your equity ($2,000), which is higher than the maintenance margin ($1,750), is greater than the maintenance margin. However, you are getting closer to making a margin call.
Further Drop
If the value drops again, let’s say by 10%, your portfolio is now worth $6,300.
Your equity: $6,300 – $5,000 = $1,300.
Maintenance margin requirement
25% of $6,300 = $1,575.
You now have a margin call because your equity ($1,300) exceeds the required maintenance margin ($1,575).
Preventing a Margin Call
A margin call is a risk every trader wants to avoid. Here are strategies to prevent one:
Set Stop-Loss Orders
Use stop-loss orders before your equity drops too low to close out losing trades.
Use Less Leverage
Lower leverage reduces the risk of large losses and margin calls. Stick to lower leverage ratios until you’re comfortable with the risks involved.
Keep a Cushion
Maintain a buffer above the maintenance margin. Having extra equity in your account can help absorb market fluctuations.
Monitor Your Trades Closely
Actively monitor your account to avoid being caught off guard. Regularly check your positions, especially in volatile markets.
Managing a Margin Call
If you receive a margin call, quick and decisive action is needed. Here’s what you can do:
Deposit Additional Funds
The fastest way to meet the margin requirement is by depositing more money into your account to bring your equity back above the maintenance margin.
Close Losing Positions
You can also close some losing positions to reduce your exposure and free up your margin.
Sell Assets:
Liquidating assets may be your last resort, but it’s better than having your broker forcibly sell them off at potentially unfavourable prices.
Risks of Ignoring a Margin Call
Ignoring a margin trading can lead to severe consequences.
Forced Liquidation
If you don’t meet the margin call, your broker will automatically sell off your assets to recover the loaned amount. This can often result in larger losses if the market is unfavourable.
Complete Account Wipeout
If the market moves sharply against you, you could lose your entire account balance. Sometimes, you may even owe the broker if your account goes negative.
Broker Policies on Margin Calls
Different brokers have varying margin trading requirements and policies on margin calls. It’s essential to understand the rules of your broker:
Margin Call Notification
Some brokers provide notifications, while others may not give any notice before liquidating your assets.
Margin Requirements
Check your broker’s initial margin and maintenance margin levels. This can vary significantly from broker to broker.
Advanced Strategies to Manage Margin Calls
Once you’re experienced, you can use advanced risk management techniques to avoid margin calls:
Diversify Your Portfolio
Diversification reduces the risk of large losses in one position that could trigger a margin call.
Hedging
Use hedging strategies like options or futures to offset potential losses in your margin positions.
Monitor Margin Levels Across Brokers
Some traders spread their trades across multiple brokers to reduce the risk of hitting a margin call in one account.
Practical Case Studies
To better understand how margin calls work in real-world scenarios, studying case studies of notable events can be helpful:
- 2015 Swiss Franc Shock
Several traders received margin calls after the Swiss National Bank removed the Swiss Franc’s peg to the Euro, causing rapid currency fluctuations.
- The 2008 Financial Crisis
Massive margin calls were triggered across the stock markets during the crash, leading to widespread liquidations.
Key Takeaways
- Be Prepared
Always understand the risks of margin trading before entering leveraged positions.
- Know Your Broker’s Rules
Understand your broker’s margin requirements and policies for margin trading.
- Use Risk Management Strategies
Utilize stop-losses, limit orders, and portfolio diversification to minimize the risk of triggering a margin trading.
By understanding and actively managing your margin trading account, you can trade more safely and effectively, ensuring you remain on the right side of a margin call.
