Importance Of Margin Call In Forex Trading
Forex trading is a risky venture and traders want to avoid risks as much as they can to avoid any unfavourable situation. However, at times, traders willingly take some risks as it allows them to earn more profit.
One such risk is making investments using margin accounts. Margin trading gives you a chance in which you can borrow funds from your broker to invest in financial assets. In this way, you get more capital to invest but at the same time, it invites the risk of a margin call.
Every forex trader goes to great lengths to avoid margin calls. Margin calls can prove to be a blunder for you. Thus, you must know everything about margin calls, how they arise and how can you avoid them.
What Is A Margin Call?
When you trade on margin, you have to maintain a margin account. This is a loan cash investment account with a broker. You can use this account for share trading. With the help of this account, a broker can lend cash to the investor to purchase stocks or financial assets. The broker locks some money to keep the trader’s position open. This money is known as margin. And the amount of money left in the account to open further positions is known as available equity.
With these two values, you can calculate the margin level. Margin level is the percentage of the ratio of equity in the account to the margin used. You can calculate this with the formula:
Margin level= (equity/used margin) *100
Now, when the margin level is high, it means you have more cash available to make further trades. However, when the margin level falls below 100%, it means all the available margin has been used and you cannot place a trade further.
In such a case, the broker requests you to deposit some funds to your account by cash or through transferring securities to bring it up to the minimum value or the maintenance margin. If you fail to do so, your account could be at risk. This warning by a broker to the trader is known as the Margin Call.
Margin Call And Leverage
To better understand the margin call, you must learn the interrelation between margin and leverage. You can call these two the two sides of the same coin. Margin is the minimum amount you need to leverage a trade. On the other hand, leverage gives you exposure to the market where you can trade large position sizes with a smaller capital outlay.
In forex trading, leverage and forex margin rate are related. The margin rate tells what percentage of the total trade value can be used to enter in a trade.
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Reasons For A Margin Call In Forex Trading
As discussed, in a margin call, a trader does not have any money left to do trading. He needs to add funds. This situation arises when the losses in trading reduce the usable margin lower than an acceptable level that is determined by the broker.
It occurs when a trader commits to use a large portion of equity as a margin. Doing this, you leave very little room to absorb losses. Some of the causes for margin calls are:
- If you hold a losing trade for a longer period that results in depletion of the usable margin
- Along with this reason, you over-leverage your account
- If you have an underfunded account that forces you to overtrade with very less usable margin
- If you trade without stop loss and price moves quickly in the opposite direction.
How Does A Margin Call Work?
If you get a margin call, you must react immediately to increase the equity in your account. For this, you can simply add more cash to your account. Or you can transfer some stocks or securities into the account. Another way is to sell some of your securities and holdings to lower the amount you owe.
Margin call got its name because brokers used to call traders to inform about the issue. However, nowadays, email or text is more common to inform traders about lower margin levels.
Whenever you first set an account with a firm, you must ask how will they issue a margin call to you. You must also know how much time you will get to respond to this call. Sometimes, firms close the positions automatically once the margin call is issued. So, you must ask the firm about this also. Generally, you get few days to fix the issue. However, if you do not respond, the firm has the right to sell off your positions to bring your account within margin requirements. In such a case, you cannot react to what positions are sold and at what price.
Basis Of A Margin Call
The rules that decide the basis of a margin call are set by the federal authorities and by the individual firms themselves. These rules make standards for the margin requirement which decides the amount of cash you must have in your account at each stage when you make a trade on credit. Margin requirements can be some percentage of your full trade price or the percentage of your full account.
The margin requirements can be of different types. There can be a minimum margin (the minimum amount you need to open an account), initial margin (minimum amount before you borrow and the maintenance margin (minimum amount to hold onto a position you have traded in.) All these decide whether the amount in your account is in proportion to the amount of leverage you are using.
Equity here refers to the value of your holding in the account minus the amount you borrowed for trading. Let’s understand this with an example. You have an account with holdings worth $20,000 and $5,000 cash. In this case, your equity is $25,000. However, if you have borrowed $10,000 to acquire these holdings, then your equity value will be $15,000.
Example Of A Margin Call
Let’s understand the whole process of a margin call with an example. Suppose you have $5,000 in your account. Now you want to open a short position (sell) for USD/JPY with single lot of 100,000 currency units.
For this, the required margin will be 3% and thus the broker will lock $3,000 from your account. This will be your used margin. Now, the amount left unused in $2,000 and this is known as free margin. In total the available equity is $5000 as no trade has started and no losses has occurred yet.
Now, imagine that you opened a trade and sold a USD/JPY currency pair for one lot. Unfortunately, luck is not on your side and you incur a loss of $2,000. Now your available equity will be just $3000 and the free margin is zero.
At this point, if you will calculate the margin level with the formula mentioned above i.e.
(Available equity/used margin) *100
The margin level comes out to be 100%. At this point, you will receive a margin call from your broker to either refill your account or to liquidate the trade.
Check Out: How To Calculate Your Risk While Trading
How Can You Keep Your Account Above The Margin?
Maintenance margin requirements vary according to the firm but it also depends on what type of securities you are holding. Maintenance margin mainly refers to the equity that you must maintain in comparison to the market value of the holdings. The Financial Industry Regulatory Authority (FINRA) has set this limit to 25%. However, most brokerage firms raise this limit to up to 30-40%.
There are different rules for different traders. A day trader must maintain an equity balance of $25,000 in their account to continue trading. When it comes to forex trades, they are mostly fully margined. The broker even gives you a chance to make money that doesn’t belong to you. The Commodity Futures Trading Commission has put a limit on leverage on major currencies to be 50:1.
Leverage in forex trading is like a double-edged sword. On the one hand, it gives you a large amount to trade but on the other hand, the more leverage you use relative to the amount deposited, the less usable margin a trader has to absorb losses. Further, if unfortunately, you incur a loss on your overleveraged trade, your account will deplete quickly.
Thus, you must place your trade with extreme caution.
How Can You Avoid Margin Calls?
No trader wants to deal with margin calls ever in his life. A margin call means you have incurred so many losses in your trade that a broker wants more amount as collateral to continue the trade. However, if you can manage your trades in a good manner, you can avoid margin calls.
Margin calls are more common with amateur buy-and-hold traders. These traders fail to get rid of a holding if it goes into losses. As a result, they keep on adding more funds to their account to maintain that losing position. On the other hand, experienced traders know where to cut the losses and liquidate the losing positions.
Some tips to avoid margin calls:
- Try not to over-lever your trading account. Your effective leverage should be less. A ten-to-one leverage is often recommended for forex trading.
- Be careful in your risk management strategies. Try to limit your losses with the stop loss.
- Try to maintain a healthy amount of free margin in your account to continue trading. You must not use more than 1% of the account equity for a single trade. Also, do not use more than 5% equity at any point of time in all your trades.
- Try to trade in smaller sizes.
- Set up alerts in your account so that you get notifications when your active trades start declining.
Margin trading involves high risks and thus, it is not suitable for all traders. If you want to trade on margin, it is advisable to first assess your financial circumstances and your capacity to tolerate risks.
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