What Exactly is Margin Call?

Not everyone has enough capital to make significant profits. Brokers help investors here. When a trader’s balance doesn’t allow for a greater trade, the broker gives him a “loan.” This is margin trading.

Margin and Margin Call

In the 90s of the previous century, the first online exchanges came into existence. Before this time, traders conducted transactions by communicating over the phone with a broker their intent to purchase or sell assets.

When the trader’s account ran out of money at the same time, the broker called the trader and notified him that his balance was reaching a critical limit (also known as a “margin” in English), and that it was essential to deposit funds in order to continue trading.

A margin call is a communication from a broker to a trader that the trader’s losses in trading are getting close to a critical level. If the trader does not replenish his account within a certain amount of time, the position will be liquidated forcibly.

The Problem-Solving Process

Everyone has the ambition to amass enormous wealth, but not everyone possesses the resources necessary to make this ambition a reality in their lives. The investor then receives assistance from the broker at this point. A “loan” is what the broker calls what happens when a trader wishes to make a larger trade than what is allowed by their current balance. The term “margin trading” refers to this form of financial transaction.

Because extending credit is a potentially risky industry, the broker is required to have insurance. This insurance is a pledge, which means that a portion of the cash in the customer’s account will be withheld in the event that a series of unfavorable conditions occur and to compensate any losses. The margin is equal to this amount. It is considered a relative indicator since its values are recalculated each time a new position is opened in the account.

Imagine for a moment that a trader has one million dollars listed on his balance sheet. It is impossible to trade with the remaining $ 350,000 since it has been set aside as collateral, which means it will be used to compensate for any losses that may occur.

It has been determined that the trader has a total of $650,000 in free funds at their disposal, which they are free to use anyway they see fit. This amount, which is the difference between the entire amount of funds listed on the trader’s balance sheet and the amount of collateral, is referred to as “free margin,” and you should already understand that it is the difference.

As a consequence of this, the trader is free to engage in any kind of transaction with the remaining amount, which is 650 thousand dollars. The expansion of the market is good news for traders, since it means that the available margin on their accounts will also expand in tandem with the market.

On the other hand, if the price moved in the opposite direction from what the trader had anticipated, things wouldn’t look quite so bright. Before our own eyes, the margin on the account is being depleted, and right at the point when the amount of money that has been lost is getting dangerously close to a threshold, the broker issues a warning to the trader.

A natural question emerges at this point, namely, what level of loss is regarded to be critical. When the losses reach a certain threshold, does the broker start sounding the alarm?

Due to the fact that it is unique to each broker, there is no single value that can be assigned to this field. Nevertheless, the following is a breakdown of the averages: between 20 and 35 percent of the total value of the collateral.

To continue with our illustration, it is simple to determine when the broker will issue a margin call to the customer: when the amount of free margin on the customer’s balance falls below approximately $105,000. (350,000 x 30 percent ).

When does a margin call occur, what precautions should be taken to avoid it, and what steps should be taken when it does take place?

Margin Call and Leverage

Leverage is the ratio of margin to the amount of brokerage credit. So, by depositing only 10,000 dollars and using a leverage of 1:200, the trader receives 2 million dollars at his disposal. A solid amount for such a small investment, isn’t it?

But do not forget that out of these 2 million dollars, the trader so far owns only his 10,000 dollars, and the remaining 1,990,000 dollars is the broker’s money. It is obvious that the broker does not intend to take risks, let alone lose their funds. Therefore, when the price of the traded asset goes in the opposite direction to the trader’s expectations, and the loss reaches a critical value, the trader will immediately receive a margin call.

An Incoming Call. What Should You Do ?

So, let’s consider a situation where everything did not go according to plan, and a margin call hung over the trader’s poor head.

The notification itself is sent by the broker directly in the trading terminal itself or by email (and most often both ways).

While this is just a notification, no enforcement action has yet been taken by the broker. And here it all depends on the actions of the trader. It does have 2 options:

Fund your trading account with additional funds. Indeed, it will help, at least for a while. But if the forecast was wrong and the price continues to deviate in the opposite direction to expectations, this action can aggravate the situation by increasing the amount of losses.

Wait. Patience in this case can play both a plus and a minus:

If everything goes well, the negative trend will be broken in the near future, and the price of the traded asset will go in the right direction, then the trader will compensate for his short-term losses at the expense of profit, avoiding additional investments. If the negative trend continues, the amount on the account will decrease, and early or later the broker will announce Stop out.

Stop out is a procedure for forced closing of a trading position due to the achievement of a critical level of losses on it.

Stop out is a more serious situation that can bring significant losses to the trader. But here it is pointless for a trader to blame the broker for what happened, and it remains only to blame himself – if the broker does not forcibly close a loss-making trading position, then he will be forced to compensate for these losses from his own pocket, and such a path will sooner or later lead to his bankruptcy.

What can be done to prevent a margin call?

As they say, the best treatment is prevention. A margin call is an alarming symptom of an impending disease, but if the right measures are taken in time, it can be avoided. How to do it?

• Do not use high leverage. Yes, the potential profit will be less, and this will have to come to terms. However, this coin has another side – the greater the share of equity in the trade, the lower the risk of a margin call.
• Diversify investment portfolio. It is clear that this is the first rule of trading, but we could not help but mention it, because it really helps, and how!
• Carefully calculate and plan the number of transactions and their amounts.
• Abandon the pyramid strategy in trading – do not open many positions in the hope of then closing the most profitable ones, and wait for the loss-making ones to break and go into plus. Remember, this strategy is extremely dangerous for beginners.
• Get rid of “unsuccessful” purchases – unprofitable assets in time. Don’t expect them to rise soon.

Do not neglect the use of stop loss for such positions. It is possible to check with the broker in a timely manner its formula for calculating the margin call parameter. Using it, you can place stop-loss orders in such a way as to prevent unwanted actions on the part of the broker.