Of the many things, traders dread, getting margin called is definitely on the top ten list. But for a beginner trader, the concept of margin call can be a confusing one to grasp. The guide below will help you understand what it is, how it works, and some tips to avoid getting margin called.
Margin Call in a Nutshell
A margin call happens when a trader’s margin account falls under the required minimum margin requirements of his/her broker. A trader’s margin account is typically comprised of positions partially purchased with leveraged or borrowed money. In order to amplify the potential returns on any given position, a trader may use leverage to open a position, which means they are buying the security with a combination of their own money and the broker’s funds.
When a position starts to lose money, you don’t necessarily get margin called right away. Depending on how much leverage you are using, it may take a substantial price move to get margin called. The more leverage you use at any given time, the higher risk you can get margin called, especially if you are trading a highly volatile market or security.
When you get margin called, the trader has two actionable options – either deposit more capital into the trading account or liquidate some of the positions they are currently holding in their account to satisfy the broker’s maintenance margin requirements.
Examples of Margin Calls
Say you buy $2,000 worth of stock with $1,000 of it fronted by your broker and $1,000 of your own capital. If your broker’s margin requirement is 30 percent and the value of the stock falls by 40 percent to $1,200, your capital effectively drops to $200, which is lower than the broker’s 30 percent minimum requirement. Note that the broker’s $1,000 stays the same and only your capital’s value is affected by the price drop.
Another example is buying one standard lot of the currency pair EUR/USD, which has a nominal value of $130,000. Say that the margin requirement set by your broker is two percent, which puts your capital allocation at $2,600. If your trading account goes below this $2,600, your account gets margin called.
How to Cover It
According to the experts at SoFi Invest, covering margin calls is a matter of depositing more cash into your trading account or reducing the number of positions you have open. Note that you’ll have to act immediately when you get margin called since your broker can choose to close some or all of your open positions to get your account back up to their margin requirements.
To avoid getting margin called in the future, it’s best to use a margin calculator before opening a position. Most if not all brokers offer these calculators as one of their dashboard features. You should also avoid opening too big of a position during highly volatile times, such as just before the non-farm payrolls or unemployment numbers are released unless you know what you are doing.