What is a margin call?
A margin call is a demand by your broker for you to deposit additional funds into your trading account to meet the set minimum requirement. Typically, traders combine their money and borrowed funds from their broker to execute a trade. If a security’s trend goes against your prediction, it could reduce your usable margin and your equity. It may be as a result of over-leveraging, underfunding your account, or hanging on to a loss-making position for a prolonged period. In the event of a margin call, you will have to deposit additional funds into your account to meet the requirement.
Example of a margin call
To have a better understanding of the margin call, let’s look at a real-world example. Let’s assume that you are a trader interested in forex trading. You open a mini account and credit it with $20,000. At that point, the details of your account will be as follows:
- Balance: $20,000
- Equity: $20,000
- Used margin: $0
- Usable margin: $20,000
To get the usable margin, subtract the used margin from the equity. It is also important to note that equity defines the probability of a margin call. If your equity exceeds the used margin, there is a low probability of receiving a margin call.
Now let’s assume that you buy the GBP/USD currency pair, with the lot size being 1.0 and a margin requirement of 1%. At this point, your account’s details will change to:
- Balance: $20,000
- Equity: $20,000
- Used margin: $200 (1% of the equity)
- Usable margin: $19,800
If you close the position at a price that is similar to the buying price, you will have gone back to a used margin of $0, a usable margin of $20,000, and equity of $20,000. However, it is common for emotions to influence a trader’s decisions. Let’s assume that you’ve become overconfident and now decide to increase your lot size to 50. With that move, you will have amplified your chances of getting a higher profit, as well as your risk of incurring hefty losses.
Now, your account will look as follows:
- Balance: $20,000
- Equity: $20,000
- Used margin: $10,000 (50 lots * margin of $200 per lot)
- Usable margin: $10,000
If the trade goes against your prediction and the price of the currency pair drops, your equity will also drop. However, your used margin will remain unchanged. Depending on how low the currency pair falls, your equity may move below the used margin of $10,000. If that happens, you will get a margin call.
What happens in the event of a margin call?
A margin call means that the broker will close your entire lot position. The execution will occur at the prevailing price. Let’s use our prior example for a deeper understanding.
In your mini account, one mini lot is equal to a dollar. Since your lot size was 50, then 50 lots * $1/pip = $50/pip. This means that if the GBP/USD pair rises by one pip, your equity will have risen by $50 and vice versa.
With a usable margin of $10,000, the currency pair may drop by 20 pips in a matter of seconds. We’ve gone for the 20 pips because, $10,000 (usable margin)/$50 per pip = 20 pips.
After the margin call, your usable margin will be $0, while the equity will be at $10,000. Just like that, you lost half of the deposited amount.
If the amount remaining in your trading account is not enough to settle the debt, you may need to seek other ways to raise funds. In extreme cases, the debt may result in a lower credit score, higher insurance rates, or even a lawsuit.
