A trader can buy securities not only with his own money, but also with funds provided by a broker. It increases both profitability and risks. When the risks go beyond the limit, a margin call occurs.
I. What is margin
When an investor wants to spend more money than he has on trade, he can borrow money from a broker. Then the collateral for the loan will be his own funds in his brokerage account, they are locked up as a kind of security deposit. This amount is called a margin. Margin is recalculated every time when a trader opens a position.
For example, the trader has $1000 on his trading account and buys shares (opens a position) that require a margin of $300. After buying the trader’s account will remain the same as $1000, but $300 will be blocked, and he will not be able to buy other shares with it. The difference between $1000 and $300 is called free margin.
The amount of margin increases or decreases as profits or losses increase. The trader will have access to margin only after he closes the trade (for example, when he sells the stock he bought).
II. What is leverage and margin trading
Leverage is the ratio of the amount of margin to the amount of loan provided by a broker. For example, if the ratio is 1:500, this means that the broker is lending an amount of money that is 500 times greater than the investor’s account. For example, the ratio is 1:100, and the trader has $1000 on his account, then he has $₽100 thousand available for trading. $1000 of this amount belongs to the trader and 99 thousand to the broker.
Trading using margin and leverage is called margin trading.
Trading on margin helps a trader make more tangible profits than if he were to trade with his own money only. The flip side of margin trading is the possibility of getting more tangible losses. However, the very device of margin trading will not allow the trader to lose more than the margin. And Margin Call allows reducing these losses as well.
III. Margin Call and Stop Out
If during margin trading, quotes did not go in the direction that the trader expected, the trader begins to incur losses. Losses reduce the margin and when it reaches a critical value, the trader receives a notification from his broker that he must deposit funds to his account. This notification is called a Margin Call.
Margin Call is a very unpleasant event. This is evidenced by the fact that traders often “curse” their colleagues, saying “May all your positions close on a margin call!
The notification goes through the trading terminal or comes by e-mail. At this stage, the broker just warns the investor – no compulsory actions will be performed.
The name Margin Call originates from the times when transactions were made by phone. So, when the Margin Call came, the broker would warn the trader by telephone that it was necessary to replenish the deposit. Now the quotes in the market are changing so fast that the broker simply does not have time to call.
The critical value leading to the Margin Call is a percentage of the pledge amount. Each broker has its own Margin Call requirements, which can be 20-30%. In our example, the Margin Call is $300. If the broker has set the value at 30%, the Margin Call can be calculated as $300*30%. It will amount to $90. This means that when $90 is left of the margin, the trader will receive a notification.
Now, the trader can act in three ways:
- Deposit additional funds to his trading account. However, this can further increase the amount of losses;
- do nothing. If the stock quotes start to rise, the trader will be able to recoup the losses and additional money will not be needed;
- do nothing. But if the stock price continues to fall, the amount in the account will decrease even more and the broker will announce a Stop Out.
If the margin call is just a warning that the trader might have problems, at Stop Out the broker will automatically close some or all positions previously opened by the trader. If the broker does not forcibly close unprofitable positions, they can exceed the amount of the initial deposit, and the broker will have to cover this difference at his own expense.
IV. How to avoid a Margin Call
There are a few ways to avoid a Margin Call:
- Put more money in your trading account than it is necessary for the deal. This kind of “safety cushion” will help save money and nerves to both investor and broker;
- if it is already coming to a Margin Call, you can fund the account without waiting for the broker to act. This will prevent or delay the forcible closing of a losing position;
- find out, from the broker, which formula is used to calculate the Margin Call. After the calculation, put a stop loss. This allows you to leave the market before it is forced by the broker;
- Not to use the leverage, and trade only with own money.