Margin is what acts as security when you trade in certain financial products, especially risky ones.
Nowadays, with online trading, often there’s little or even no warning. When a margin call happens your account can simply be liquidated – closing all positions, or at least enough of it to bring it back within the minimum margin requirements. And the next time you check your account you find your positions have been sold off at “fire sale” prices.
If a margin call is triggered and positions are automatically closed by way of market fill orders, it can be at adverse prices. If things get really bad the remaining cash balance left in the account could even be negative. That means you now owe your broker money.
For that reason it pays to understand margin rules and protect against margin calls ever happening in the first place.
Trading on Margin Explained
In foreign exchange most traders become accustomed and fairly comfortable with trading on margin. Margin trading is a form of leverage where, in effect, you borrow money to speculate on price movements.
What this means is that you can bet on the price rise or price fall of an asset without having to front the entire amount of money it would take to buy those assets outright.
A standard foreign exchange contract for EUR/USD is long EUR 100,000 and short and equivalent amount of United States dollars. However since both are major currencies, the exchange rate between them doesn’t generally change by very much. This means the variation in the value of one EUR/USD contract may only be a few hundred dollars each day.
It would be very inefficient for traders to have to put up front EUR 100,000 to speculate on the movement of the currency pair by a just a few points. If this were so, few people would speculate in currency markets and that would greatly reduce the liquidity and stability of the market as a whole.
To address this, clearing firms and brokerages allow margin trading. With this they set a minimum amount or margin that you must keep in your account to open and hold each financial contract.
Margin Call Example
For example suppose the minimum margin for opening the above EUR/USD contract is 1% or EUR 1000. In other words every 1 euro of your money can control up to 100 euros of assets.
We then have:
Contract size: EUR 100,000
Initial margin required 1%: EUR 1000
A trader is only required to keep EUR 1000 free margin in their account to hold one EUR/USD contract.
The free margin is the amount of cash in the account minus any unrealized losses. Any other open positions will also reduce the free margin. If the account’s free margin falls below EUR 1000 at any time, this would trigger a margin call and the positions would be closed.
When calculating margin, some forex brokers take into consideration other holdings. That means if there are other positions in the account that hedge the risk of EUR/USD, for example an opposing long and short contract, then the margin requirement will be less. The amount will vary according to the specific margin formula used by the broker.
Conventionally there is a 50% hedging rule so that your margin would be reduced by one half if the position is entirely hedged. Though precise margin rules vary from broker to broker and can be complex. It is worthwhile to check the rules that apply to your account in advance.
SPAN margin rules
SPAN stands for Standard Portfolio Analysis of Risk, and is the method many exchanges and clearing houses use for calculating margin requirements for their members.
What SPAN does is takes into consideration all of the positions held by a client using a form of VAR – or Value at Risk analysis. But unlike standard VAR, SPAN also includes extreme scenarios in its calculations. It then calculates a SPAN margin based on the associated risk of the entire portfolio of assets.
The use of SPAN means that positions that hedge one another offset risk and can then reduce the amount of free margin that the client needs to maintain to hold those positions.
SPAN usually results in lower margins for clearing firm members as well as end traders because the entire portfolio is used in the assessment of risk. This allows for better use of capital.
Initial and variation margin
Sometimes there is both an initial margin and a variation or maintenance margin. The initial margin is the amount needed to enter into the contract in the first place. The variation margin, which is lower than the initial margin kicks in if the mark to market value of the contract falls.
Variation margin is calculated each day based on the instrument’s previous day’s closing price. This is known as marking to market.
For example, if the initial margin for one euro FX future is EUR 1500 and the variation margin is EUR 1000 this means that a trader must have a free margin of at least EUR 1500 to enter the contract.
Once open they must then maintain a free margin of at least EUR 1000 in their account to prevent a margin call. The variation margin is EUR 1000, so if the value of the euro FX position were to fall by more than EUR 500 at the close that would trigger a margin call if the trader’s free margin is less than EUR 1000 on the following day.
Beware of Changes to Margin Requirements
One thing that catches people out is that margin rules can and do change. That can require adding more funds immediately or risking a margin call.
This often happens at the worst conceivable time for the trader. For example during the Brexit referendum some brokers increased their margin requirements on anything with exposure to British pounds.
If the margin requirements change, you’ll be notified and usually have a very short period of time to fund your account to adequate levels or risk having positions sold.
What Happens When You Can’t Pay?
If your account’s free margin falls below the minimum required level, your handler will automatically sell positions in your account to cover the shortfall. However the nightmare may not end there.
In adverse market conditions or with excessive leverage, there is a real possibility that the account balance becomes negative once the positions are closed.
This happened to a lot of traders during the Swiss National Bank’s unpegging of the franc to the euro a few years back.
Five Simple Tips Protect Against Margin Calls
The golden rule to handling margin calls is not to get there in the first place. The following are tips to prevent you ever getting into a margin call situation.
1. Lower leverage
While margin trading can increase profits, it also elevates risk by the same amount. Traders who aggressively leverage their accounts are far more likely to receive margin calls than those that don’t.
2. Understand the product
Trading in products that are not fully understood is a common reason for receiving an unexpected margin call. The pricing of many financial products, especially derivatives, can be erratic especially at times of change such as rising or falling volatility, risk aversion, and changing interest rates.
3. Beware of liquidity and event risks
Times of reduced liquidity and/or increasing volatility can greatly increase the chances of a margin call. That means holiday periods and throughout economic events like critical interest rate decisions and important elections. At these times, minimum margin requirements can increase suddenly and without notice.
4. Stop losses
Stop losses are a useful means for managing losses but they won’t always protect against adverse market conditions particularly when liquidity dries up. The stop losses should be placed well above the thresholds where a margin call becomes imminent.
5. Check regularly
A margin call can often be avoided simply by managing the account effectively and following good risk control, for example using VAR. It’s always better to be on top of a situation before it gets out of your control rather in than the hands of the broker.