What is a margin call and how do you prevent it?
If you invest in derivatives such as CFDs, chances are that sooner or later you will come into contact with the term ‘margin call’. But what is a margin call? A margin call is a situation where there is no longer enough money in your trading account. Your trading position can then be closed automatically. In this article you can read what investing on a margin is. We also discuss how you can avoid a margin call.
How does investing or trading on margin work?
Many brokers offer the possibility to trade on margin. When you trade on margin, you only have to deposit a small part of the total investment. The remaining amount is financed by the broker. When you invest on margin, you apply a leverage: with a smaller amount you open a larger investment position. It is then possible to open an investment of, for example, $500 with an amount of $100. When you trade on margin you have to pay extra attention.
The margin on your position
The margin that you are allowed to use differs from broker to broker. When the maximum leverage is 1:5, it means that you have to deposit 20% of the investment yourself. So, if you want to buy Google shares for $10,000, you’ll have to deposit $2,000 yourself. The remaining $8,000 is then deposited by the broker.
In this case, you only risk $2000. However, you can achieve the same investment results as you would with an investment of $10,000.
The required margin is often indicated by a broker
The maintenance margin
The broker expects you to have enough money in your account to cover your trading positions. When you use a margin of 500%, the broker puts in five times as much money. The price only has to drop by 20% before your full deposit is gone.
Brokers therefore use a so-called maintenance margin. The maintenance margin indicates which part of the value of the total investment should always be present on your account.
If the maintenance margin is 10%, you must always have at least $1,000 in cash in your account for an investment with a value of $10,000. This amount may consist of profits from other investments or from your assets. If you do not meet this requirement, you may have to deal with a margin call.
What is a margin call?
You will receive a ‘margin call’ when there is no longer enough money in your account to keep the existing positions open. This happens when the value of your account has dropped more than is allowed according to the maintenance margin. Current gains on another investment can also be used to meet the maintenance margin of your investments. If the value of your account falls below this level, you may have to deal with a margin call.
The meaning of a margin call is simple: the broker then asks you to deposit more money. If you don’t do this and the result of your position doesn’t improve, you can lose the entire position. The broker can then liquidate all your investments to ensure that you meet your margin requirements again. When you start investing on margin, it is important to keep these risks in mind.
Example of a margin call
Let’s say you deposit $1,000 into your account, and you open an investment with a value of $5,000. In this case, you use a margin of 500% or a leverage of 1:5. When the share decreases 10% in value, you lose $500. After all, you ended up buying $5,000 worth of shares. When the maintenance margin is 10%, you may already be in trouble. After all, you no longer meet the margin requirements.
To keep your position open, you have to deposit more money. When the money in your account gets close to $0, the broker will execute a margin call. If you don’t deposit money, the position is usually automatically closed. It is not possible to lose more money than you deposit in your account.
If you have multiple current investments with a broker, the result of investment A can influence investment B. Suppose you are still in the loss-making investment in the example above. However, you have also invested in another share with $1000, and you have applied a margin of 500% here too. However, this share has increased by 10%. The current profit of this share compensates for the loss at the other position. In this case, you would not receive a margin call.
So, when you open multiple positions, you have to be careful. One position that performs very poorly can cause all trades on your account to be closed. You won’t be the first trader to blow up his entire investment account because of a margin call.
Explanation of how margin calls work
How can you avoid a margin call?
It is wise to avoid a margin call. After all, with a margin call, you lose all the money in your account and your positions are automatically closed. You can avoid a margin call by making sure there’s always enough money in your account.
A good tool that can help you with this is the stop loss. With a stop loss, you can set a value where your investment is automatically closed. Read more about using a stop loss here.
Within your broker account, the following numbers are typically displayed. The balance is the amount that’s in your account. Your equity is the current value of all your trading positions. The value of your trading positions consists of your deposit plus open profits and minus open losses. The margin is the minimum amount that should be present on your account to prevent a margin call. The free margin is the amount you can still use for new investments.
What are the costs of investing on margin?
Trading or trading on margin is not free. You pay a funding interest on this. You pay this interest for every day you keep the position open. When you trade on margin you need a higher return to achieve a positive result. In this article we explain how these financing costs are calculated.
Set a guaranteed stop
You can protect your positions with a guaranteed stop. A guaranteed stop automatically closes your position when it decreases to a certain value. By setting a guaranteed stop, you can limit your loss on a certain position.
A guaranteed stop is often more expensive than a normal stop loss. With a normal stop, you can still lose more money within a very volatile market. With a guaranteed stop order, the broker guarantees that your position will be closed at the declared value. It is therefore especially advisable to use a guaranteed stop loss for very volatile securities.
CFD trading: a short introduction
A Contract For Difference (CFD) is a financial product that allows you to benefit from a price increase or a price fall. A CFD is a contract between a buyer and a seller. The difference in value of the underlying security determines your profit or loss. This result will be settled as soon as the contract is closed. CFDs have a leveraging mechanism. This means that you can take a large position with a relatively small deposit.