Margin Calls

What is a Margin Call and Why is it Important?

The margin call is every trader’s worst nightmare, and frankly speaking, no trader should ever pray to experience it, even though experiencing it once or twice may be necessary as part of the trading experience, and if done on a small account.

A margin call is an automated instruction issued by a broker to the trader to re-capitalize the trading account so as to be able to maintain the margin levels required for active positions to continue to remain open.

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Usually, failure to adhere to this instruction will result in all open trades being closed automatically so as to preserve the broker’s funds which have been used as leverage for the trade. But the question that must be answered in order to understand what margin calls about is: what exactly is the margin, and what is the role it plays in sustaining trading activity in the marketplace?

Margin in the Financial Markets

The forex market operates on leverage. Forex movements are in the order of ten-thousandths of a point. Such small movements will require large capital for the returns on such trades to be reasonable. This is why brokers provide the opportunity to traders to use leverage in shoring up the worth of their positions. With leverage, the trader only needs a little money to control a large forex position.

However, part of the deal is that traders must provide a portion of their investment capital, which will be leveraged upon for trading activity to be carried out in the market. This investment capital is known as the margin, and it serves as a collateral to run the trade on the borrowed funds. If the trader is profitable, the trader reaps the full complement of the profits from the trade. If the trade ends in a loss, then the loss is deducted from the trader’s margin. Any losses that surpass the trader’s margin would lead to such losses deducted from the rest of the un-invested capital. When the un-invested capital in the trader’s account is depleted by ongoing losses, then a margin call would be issued.

Such margin calls are usually academic most of the time. Unless a trader has a credit or debit card which would be used to make INSTANT deposits into the account, there is usually not enough time to make deposits required to stop the trades with ongoing losses being closed out.

Causes of Margin Calls

The commonest causes of margin calls are highlighted below:

a)    Putting on too much risk in trades.

The effect of excessive risk in triggering margin calls is best seen when a trader sustains a series of losses. If a trader uses a stop loss of 100 pips per trade, with a 0.2 lot size per trade on a $5,000 account, it would take 25 trades to liquidate the account. If 0.5 lots are used, then it would take just 10 trades to get a margin call issued. More risk assumed on an account will increase the likelihood of suffering a margin call.

b)    Trading Volatile Assets

When a trader trades currency pairs or assets with large spreads and extreme volatility, then the chances of a margin call occurring becomes a lot higher, especially when the trading account is not well capitalized.

For instance, a trader with a $3,000 account should ideally not be trading a full contract gold asset. Gold has the propensity to make intraday movements of up to 10,000 points. A trade may therefore head deep into negative territory before it becomes positive. In addition, trading such assets would require usage of large stops. If the trader makes it a habit of trading highly volatile assets with large spreads on under-capitalized accounts, then the chances of a margin call being issued increases.

c)     Holding Too Many Positions

This is just as bad as using excessive risk on trades. When a trader has too many open positions, overall control becomes a lot more difficult. It requires much higher margins to control multiple positions than to hold one or two positions. If one trade position out of many goes bad, it could mean a lot of trouble. The trader would then have to start closing some positions (including positions that would have turned decent profits) in order to maintain control,.

 The Margin Call

When a trade is in a loss position, the trade maintenance margin on the account starts to erode. When the maintenance margin is gone, the account capital which was unused in the trade starts to get eroded as well. A margin call will not occur until losses continue beyond a critical point. If losses continue, the margin call is issued and the trader’s account balance disappears into thin air.

 How to Avoid Margin Calls

As bad as margin calls are, they can be avoided by applying these simple tips:

a)    The simple act of reducing risk is usually all that would be needed. Reducing risk entails making sure that a maximum of 3% is exposed to the market. This percentage includes all open positions, and not 3% per trade. Another risk reduction strategy is to make sure that entry points are well timed so as not to have to use large stops to protect the trade.

b)    Make sure your trading accounts are well capitalized. Open the right type of account for your account size. Traders who can only afford $1,000 in trading capital have no business toying with standard lots. They are better off trading micro accounts with mini or micro lots. Leave the big money positions to the high rollers who have the money.

c)     Do not take on too many positions at once. Once more than 2 positions are in the market, they are harder to monitor and control and mistakes are bound to happen here.

Adam

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Adam is an experienced financial trader who writes about Forex trading, binary options, technical analysis and more.

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