Margin calls are a crucial aspect of forex trading that traders strive to avoid. To do so, it's important to understand what causes a margin call and how to prevent it. This article provides a detailed
- overview of margin calls,
- including an introduction to margin and leverage,
- the causes and procedures of a margin call,
- tips for avoiding them.
MARGIN AND LEVERAGE
To comprehend a forex margin call, it's important to understand the related concepts of margin and leverage. Margin is the minimum amount of money needed to make a leveraged trade, while leverage allows traders to gain greater market exposure without having to fully fund the trade. However, trading with leverage carries risk and can result in both large profits and large losses. For tips on minimizing risk when trading, check out our guide to risk management.
WHEN DOES A MARGIN CALL HAPPEN IN FOREX TRADING?
A margin call is when a trader needs more money in their account because they have used up their free margin. This can happen when trading losses lower the free margin below the broker's minimum level.
Margin call is more likely when traders risk a lot of their equity for used margin, leaving little buffer to cover losses. The broker requires this to control and lower their risk.
Some common causes for margin calls are, in no specific order:
- Not closing a losing trade soon enough which lowers free margin
- Using too much leverage with your account and the first cause
- Having a poorly-funded account which will force you to trade with too little free margin
- Trading without stops when price moves strongly against you.
WHAT IS THE OUTCOME OF A MARGIN CALL IN FOREX TRADING?
When a margin call happens, a trader is forced to close their trades. The reason is two-fold: the trader does not have enough money in their account to keep the losing positions and the broker is now responsible for their losses, which is equally bad for the broker. It is important to know that leverage trading can sometimes make a trader owe the broker more than what they have deposited.
Below is a visual representation of a trading account that has a high risk of getting a margin call:
Deposit: $10 000
Number of standard (100k lots traded): 4
Margin percentage: 2%
*Used margin: $9 000
Free margin: $1 000
*The used margin is calculated as follows with the EUR/USD at 1.125:
Trade size x price x margin percentage x no. of lots
$100 000 x 1125 x 2% x 4 lots = $9 000
For simplicity, this is the only position open and it uses all the used margin. It is easy to see that the margin needed to keep the open position takes up most of the account equity. This leaves a free margin of only $1000.
Traders may think that the account is in good shape; however, the use of leverage means that the account is less able to handle large movements against the trader. In this example, if the market moves more than 25 points (not including spread) the trader will be on margin call and have the position closed ($40 per point x 25 points = $1000).
HOW CAN A FOREX TRADER REDUCE THE RISK OF MARGIN CALL?
Leverage is often and rightly called a double-edged sword. The meaning of that statement is that the larger leverage a trader uses – compared to the amount deposited - the less free margin a trader will have to cover any losses. The sword only cuts deeper if an over-leveraged trade goes against a trader as the losses can quickly reduce their account.
When free margin percentage hits zero, a trader will receive a margin call. This only shows more reason to use protective stops to cut potential losses as short as possible.
To further show the effect of leverage on a trader’s account, consider the following example where leverage is the only difference for these trades:
In the end, we can’t predict what will happen with the price movement tomorrow so be careful when choosing the right leverage used when trading.
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