Getting a Margin Call is obviously a nightmare for any trader, and we know the problem. So, today we have decided to write this article to guide you on: What is Margin call in forex trading? how do margin calls work? and how to avoid margin call? So, let’s get started.
What is Margin Call in Forex Trading?
Forex brokers almost always offer margin facility to traders. That means the broker provides you the opportunity to do trading with money you don't have. The average leverage you get while trading forex is very high and often between 50:1 and 200:1 (sometimes even more 400:1).
Leveraging your account to the highest 200:1 ratio means that even with a slight drop in the currency exchange price can wipe out your account's usable margin (balance). That is the time when you get a margin call from your broker.
So the simplest answer to the question "What is margin call?” Or “what does margin call means” is that it's a demand from your broker to put more money in your account if you want to continue your existing trades. By other means, this is the way brokers inform you about a heavy loss in your trade.
Now when you got the above answer, some more questions might be coming to your mind. Those questions are like: how do margin calls work? what is the cause getting a margin call? and moreover, how you can avoid getting a margin call?
Forex Margin Call - Explanation:
The margin call can be explained in different two ways. Both are the same concept, just expressed differently. I’m including both for your reference, and also explain them later.
The first way of definition, "The margin call is something that happens if your total equity value (asset value) becomes equal or less than your used margin".
The second way of definition can be expressed as "The margin call trigger when the usable margin at your account becomes 0 (zero) at any given point in time".
When that happens, you can expect to get a call from your broker asking to deposit more money into your trading account. If you failed to do so, then they will close all your running trades at market price.
I know the above descriptions are hard to understand, so we’ll try to explain how margin calls work by providing some suitable examples.
[Before proceeding further, if you are unsure about what is margin, leverage, used margin, and usable margin then follow this link to our previous tutorial: What is Forex Leverage and Margin? How They Affect your Trades?]
How Margin Calls Work?
Let’s assume you have started your trading career with $5,000, which you have deposited in your newly created trading account.
So, if you log in to your account you will see that it is showing some figures somewhat like this:
Here you have to remember this formula:
Usable Margin = Equity - Used Margin
Equity is the net present value of your total investment. (i.e. - Used Margin + Cash in Hand)
Used Margin is the total amount money you have used as margin (or the amount of money locked in by your broker)
Usable Margin is the amount of free money in your account that you can use (i.e. - Cash in Hand).
So, it’s the Equity that is used to determine and trigger the margin call, not the account balance.
As long as your Equity value is greater than your Used Margin, you will not have any Margin Call. [as your usable margin will be higher than 0 (zero)]
( Equity > Used Margin ) = NO MARGIN CALL
( Usable Margin > 0 ) = No MARGIN CALL
But If your trades go againt you to some extent and your total Equity value equals or drops below your Used Margin, you will receive a Margin Call. [i.e- Usable Margin will become less or equal to 0 (zero)]
( Equity =< Used Margin ) = MARGIN CALL
( Usable Margin <=0 ) = MARGIN CALL
Let’s assume your broker takes 1% margin from you (i.e. - providing you a max of 100:1 Leverage). And you buy 1 mini lot of EUR/USD pair (10,000 Unit).
If price remain constant, then your equity value would be same as earlier ($5,000), but your used margin would now show $100, and usable margin would be $4,900.
If you sell it back at the same price you bought it, then your Used Margin would return to $0.00 and your Usable Margin would go back to $5,000. Your Equity would remain unchanged at $5,000.
But you have dreamed of extreme profit and hence, instead of buying 1 mini lot you have bought 40 mini lots of EUR/USD.
So now you are using the margin of
(40 x 10,000) x 1% = $4,000
In that case, your equity would not change (remain $5,000), your used margin becomes $4,000, and your Usable margin changed to $1,000.
But your dream turns opposite and EUR/EUSD starts to fall.
We know from the Lot value calculation chapter, that the value of 1 mini lot moves $1 per pip. Therefore, for 40 mini lots you bought, you will lose (40 x $1) = $40 per pip of downward movement.
[See Also: What are Pip and Pipette in Forex]
So the value of your Equity would also decrease by $40 per pip, and same would happen to usable margin.
Let’s assume the price drops by 25 pips, which is quite possible for a volatile pair like EUR/USD.
So, for this 25 pip movement and with a 40 mini lot position, you would lose (25 x $40) = $1,000
Now your Equity became ($5,000 - $1,000) = $4,000, which equals to your Margin Used, and Your Usable Margin drops to ($1,000 - $1,000) = $0.
This triggers an Alert at your broker’s end, and hence you get the MARGIN CALL!!
At this point, you entire trade position of 40 mini lots EUR/USD would be closed by your broker in current market price. And your account would now look like as below:
The EUR/USD only moves 25 pips and you blow up your $1,000 of capital. This is 20% of your initial account balance.
But Wait! For making the example much easier to understand we even haven’t taken care of the Spread. With Spread in place, you would have got margin call even before moving down 25 pips.
[See Also: Understanding the Bid/Ask Spread]
This is the reason why you must not take excessive leverage or utilize your full margin. Using excessive leverage and having a lower margin is the deadliest combination a trader may face.
Ok, Let me come to the most awaited point that how to avoid Margin Call?
How to Avoid Margin Call?
There are two simple ways for you to avoid Margin Call. You may follow any of this to stay on the safe side while trading forex. And moreover, don't get too much greedy at any point of time while trading.
So the strategies you can take to avoid margin calls are:
Open a "cash only" account with your broker. Though it's little inconvenient (Oh! you are here because of low margin requirement), it would not allow you to create margin debt. You can still trade with leverage in some cases such as doing options trading.
Only take positions using lower leverage, and place a stop-loss order by doing a proper calculation. And moreover, don't use more than 50% of your account balance for paying margin. That way, no matter what goes wrong, your maximum loss would be under your span of control.
One thing to remember, that your broker may not wait for you to deposit more money into the account and close your active trades within a few seconds of getting a margin call.
We hope that you have enjoyed the above article describing the margin call, how it works, and how to avoid it. Be with us to explore forex trading, stocks trading, and other money-making opportunities.
Leave us some comments if you have any questions about margin call.