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Margin Calls Explained

margin call explainedA trading account can only grow if the trader follows specific money management rules, as it is not possible to win 100% of the time. There is no holy grail in Forex trading, and no magical recipe to make money. The only thing that Forex trading virtually guarantees is that with hard work and discipline, profiting from it is possible.

Psychology Matters Most.

The way to start Forex trading is straightforward. All a trader needs to do is the following:

  • First thing first, find a good broker. The article dedicated to how to choose the right Forex broker here on our Forex Trading Academy shows the things to watch for, and offers a nice guide to finding the perfect broker.
  • The next thing to do is to open a demo account with that broker, and practise. Trading on a demo account is advised as it offers a glimpse of what the broker is doing with the spreads when the market is volatile, and how the overall execution and trading work with that broker. It should be mentioned here that demo trading is tricky, as demo trading platforms do not 100% reflect the real trading environment.
  • After trading for a while on a demo account, you should open a live account with the same broker, and then trading for real can start.

It looks simple, but the steps above are not followed by many traders, even though they are three such simple things to do. The reason for that is human nature, as psychology plays an important role when trading financial markets. The desire to make a profit is so strong that the basic safety rules tend to be forgotten or ignored. What happens next? The broker gives you a margin call!

The Inevitable Margin Call

For every trade taken in a trading account, the broker blocks a corresponding margin needed to keep the trade floating. By the time the trade hits the stop loss or the take profit, or it is simply closed, the margin is released and the process starts all over again. Having multiple open positions, and with the market going against them, the natural tendency is to add to those losing positions, and in this way the margin becomes so scarce in the trading account that even a small push further in prices will put you out of the game. However, this does not happen without notice, as by the time the margin level drops below 100%, the broker will start notifying you by email that the margin in the trading account is no longer enough to sustain the open positions, and instruct you to either add more funds to the trading account or start closing the positions in order to free up the margin.

If none of the steps above are followed, the broker will start automatically closing the trades, and if the market still goes against the open positions the trader will end up with the trading account being wiped out. This is what a margin call is, and what it does to a trading account. The thing is that a margin call is really healthy from a psychological point of view as long as it does not happen often. The trader is brought to reality, and now starts to realise that ignoring those three steps mentioned at the start of this article was a fatal mistake.

Learning from Earlier Mistakes

Receiving a margin call can be a great opportunity to ask the following question: Is trading suitable for me, or do I have what it takes to trade profitably? It is often only from this moment in time that trading is taken seriously, and that people will start investigating some more about what to do to trade profitably.

There’s no shame in admitting defeat or failure, as long as one learns from it. This is why I mentioned at the start of the article that people fail to follow those three simple steps. Human nature is such that we rather learn from mistakes than follow a simple path to success.

How to Avoid a Margin Call

A simple answer to this question is to simply have a lot of funds in a trading account, and to constantly add more than the open positions. Unfortunately, while this will certainly work, it is not usually realistic. The idea behind Forex trading and trading in general is to grow an account in such a way that in the end trading for a living becomes a reality. A sound money management plan is the cornerstone in avoiding a margin call. You can lose money in a trading account, but the broker will not give you a margin call if you are applying money management and risk management correctly.

There are many money management techniques to be applied, and here on our Forex Trading Academy, we’re going to cover them later. At this moment in time let’s just say that risking only a small percentage on each trade is a simple way to avoid getting in trouble again. Perhaps the simplest thing that people do not follow is to set a stop loss on the open trades. Markets can be so violent that without a stop loss a margin call can come in a blink of an eye. As a matter of fact, sometimes even a stop loss can’t help. The example that comes to mind is the SNB (Swiss National Bank) dropping the 1.20 floor on the EUR/CHF cross, as many traders were on the long side with stop losses just below 1.20. Those stops could not protect the account from being wiped out, as by the time the SNB dropped the peg there was no market for thousands of pips; and by the time there was a market and the brokers closed the trades, the accounts were wiped out. Not only did the traders lose the money in their trading accounts, but brokers also called for the difference between the actual level the trades were closed at and the initial stop loss level.

Trading is a serious business and a risky one, and if one is to survive and make a living out of it, risk management is a must. Knowing what a margin call is will certainly help, but knowing how to avoid it will help a lot more.

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