Forex Education


Margin and Margin Call

Forex Margin is basically the difference between the production cost of a product/service and its selling price. It also denotes the ratio of a company’s proceeds and expenses. In Forex trading, ‘margin’ is the deposit made by the trader to maintain open positions. It is neither a fee nor a transaction cost rather margin amount is set aside from the main account of the trader.

 

Breaking Down “Margin”

Margin is basically the difference between the production cost of a product/service and its selling price. It also denotes the ratio of a company’s proceeds and expenses. In Forex trading, ‘margin’ is the deposit made by the trader to maintain open positions. It is neither a fee nor a transaction cost rather margin amount is set aside from the main account of the trader. Trading on the margin is quite risky as there is no certainty and the profit or loss made can be high. To buy on margin means purchasing an asset where the trader or investor has to pay only a certain portion of the asset value and loan the rest from the broker or bank. The lender (say, broker) takes the funds in the securities account as a collateral. For instance, if an investor wants to invest $5,000 futures contract on margin where the margin is 10% then, he must pay $500. The rest of amount is borrowed by the investor from the broker or bank. The strategy is quite profitable in cases where the investor expects high returns from the trade.

 

Breaking Down “Margin Call”

The margin call is made by the broker when the account value of the investor goes below a value calculated by the broker with a particular formula. At this point, the investor has to deposit more money into the securities account or else sell some of his assets. The need of a margin call will arise only after an investor or trader will borrow money from the broker to invest in an asset. The equity (assets – liability = equity) in the investment that an investor has is equal to the market value of the securities without the borrowed funds. If the equity (as a percentage of the total market value of securities) of the investor goes below the maintenance margin which is the percentage requirement set by the brokers then, a margin call is generated. The minimum maintenance margin set by the federal laws is 25%. The maintenance margin percentage otherwise may differ from one broker to another.

 

An Example

Suppose the investor buys $100,000 worth of stocks by paying 50% from his own funds and borrows the rest from his broker. Let’s take the minimum maintenance margin (25%) as the one offered by the broker. Therefore, during the time of purchase, the equity of the investor is $50,000 (Difference between Market value of securities and the loan). In this case, the equity can be said to be the 50% the market value of the securities (equity amount divided by total market value of securities).

Let’s assume that the price of the securities purchased fell to $60,000 on the second day of trading. Thus the investor’s equity will be $10,000 ($60,000 - $50,000). But the requirement is $15,000 equity at least to stay above the maintenance margin. At this point, the broker is bound to make a margin call and the investor will have to deposit $5,000 in cash to fulfil the requirements. This deposit has to be made by the investor usually within 24 hours. The investor also has the option to transfer approved stocks to this portfolio. If the investor fails to deposit the required amount then, the broker will have the liberty to liquidate securities of the investor to meet the maintenance margin rules. The only plus point in the brokers using the collateral is that the investors being able to stay in the game.

 

Actions Taken if the Investor Fails to Meet a Margin Call

The downside is that if the investor fails to recover the situation of the margin call then he can run into debts. After the broker has liquidated the securities the investor will find the leftover amount the investor owed has now turned into an unsecured debt.

  • The credit agencies will be reported on the debt and this will make it difficult for the investor to borrow money. This will also adversely affect the investor’s credit score. The debt incurred due to this margin call may make other lenders cut off access for the investor to their products or raise their interest rates.
  • Worse situation means that universal default will be implemented and the investor will find that the insurance rates on his car, home and other policies will increase substantially. If the investor is looking for a job then, he may find it exceptionally difficult to land one. This is because credit histories represent responsibility and capability in some states during recruitment.
  • The broker can also choose to take the investor to the court. It will involve some serious legal costs. The process of breaking free from this state depends upon the rules and regulations of the region the investor is living in. the worst scenario is that the state may disclose the investor’s financial situation and personal property may be seized.

 

Ways to Avoid Margin Calls

  • The investor should open a “cash only” account at the broker company. It may be a little inconvenient but it will save the investor. This means that the investor will have to pay upfront the value of the securities in cash at the time of acquisition. The investor can continue to play the market of stock options even when he employs leverage within a cash account. The investor should contemplate to Buy a Put options on the stock rather than shorting a stock. This way the investor will either make a profit or lose 100 percent of the amount that he had invested initially.
  • The investor should keep aside at least 10 percent or 20 percent that will act as a cushion during any such situation in an FDIC-insured bank account. U.S. Treasury bills are another destination for storing that amount. This way the investor will be able to save himself even in worst case scenarios. However, the broker does not always give the investors the chance to satisfy the margin call and liquidate their securities.

Considering all the risks involved the investor should thoroughly study the market and set aside a certain percentage before actually investing in the assets.

Risk Warning: Trading may not be suitable for everyone, so please ensure that you fully understand the risks involved. Especially trading leveraged products such as Forex and CFDs carry a high degree of risk to your capital and can result in the loss of your entire capital. Only invest with money you can afford to lose.