Margin Call: a guaranteed limited risk

In the futures market, a losing position may go beyond the deposited margin, and the trader will be liable for any resulting deficit in the account. In Forex this will not happen as the risk is minimized through the mechanism of a "margin call".

Most online trading platforms have the capability of automatically generating a margin call when your margin deposits have fallen below the required minimum level because an open position has moved against you.

In other words, when the losses exceed the deposit margin, all open positions will be closed immediately, regardless of the size of positions held within the account.

Because you can never lose more than what you have deposited in your brokerage account doesn't mean that you don't have to manage your risk. It's important to take time to understand the risks associated with margin trading. Make sure you fully understand the mechanism, and in case there is anything unclear to you, be sure to ask your broker-dealer about its margin conditions.

Can the available balance be used as margin to open further positions? Usually broker-dealers allow you to use your available balance (deposit +/- open trades) as a collateral to open further positions, allowing thus to use as further margin those funds from unrealized positions in benefit. This strategy has its inherent risks because a reversal in your positions, turning them into negative territory, can rapidly originate a margin call. Should a margin call occur, make sure that you are left with more capital in your account balance than what you had before opening the positions. You can manage your positions in such a way that despite of a margin call you are left with more capital than in the beginning.

 

Leveraged Trading

Trading currencies on margin lets you increase your buying power. If you ask your broker-dealer what their margin requirement is for a standard lot they will give you a relatively small amount, typically $1,000. When you trade with $5,000 in margin and you control 5 standard lots worth of $500,000, that’s a 100:1 leverage, because you only have to post one percent of the purchase price as collateral.
This means the trader has to have at least $5,000 ($5,000 + spread to be more precise) in the margin account to trade 5 full size lots.

Now you understand why the rollover amount will depend on the size of the transaction: with higher leverages, the interest differential the broker-dealer pays or charges will proportionally increase, because you are controlling a larger amount of currency, even if you don't have that amount in your account.

The normal margin requirement is between 1% and 5% of the underlying value of the trade, that is a leverage between 100:1 and 20:1, although some broker-dealers provide extreme levels of 200:1 (0.5%) and more. Most dealers scale their margin requirements which allows smaller accounts to use higher leverages like 200:1, and bigger accounts to use 50:1, or 10:1.
The currency denomination for the leverage depends on the brokerage through which you execute your trade, but it is usually US Dollars.

Despite being very attractive for small investors, leverage is one of the main reasons people lose money trading Forex. The purpose and use of leverage can be a difficult subject to understand, but it's mandatory if you want to avoid the traps it may represent. It is not in your interest to misuse the concepts of margin and leverage. Professional traders are very careful about it- that is why they stay in the market in the long term.

A common way to calculate the margin required per trade is the following: suppose you have 100:1 leverage from your broker-dealer. The maximum trade size is then calculated as amount in USD x 100. Supposing you decide to buy one standard lot of GBP/USD. To figure out the amount of capital which has to be set aside as margin for the value of the deal, we need to take the current rate for GBP/USD (let's say 2.0200) and do the following:

                                    (2.0200 * 100,000)/100 = $2020.00

Should the account balance equal or drop below the margin requirement, the broker-dealer would liquidate all open positions on a margin call. That means that using $2020 in margin and trading one standard lot with $10,000 in the account, if the trade would go negative by $7981, a margin call would occur.

                                   IF (margin account) – (position value) < min. margin requirement
                                   THEN

                                   $10,000 – $7,981 = $2,019 < $2,020 → MARGING CALL!

In reverse quote pairs, the currency denomination for the leverage is already in USD. In the case you would decide to buy a standard lot of USD/JPY at a rate of 105.00, then you would need a $1,000 margin for a $100,000 lot with a 100:1 leverage.

Let's say you have an account with $10,000 and you open that USD/JPY position. The broker-dealer won’t automatically close the trade if the losses exceed $1,000. The margin call will occur only when your net balance is less than $1,000. So if the position goes against you and accumulates $9,001 worth of losses, your position will be automatically closed and you will be left with $999 in your account.
Broker platforms already include the spread and the rollover into the equation, but remember that these variables also influence the net balance.

Dirk Du Toit insists a lot on explaining this subject to his students. In his book, “Bird Watching in Lion Country”, he states:

Margin required and leverage is not the same thing. "Low margins" ="low margin requirement" ="high gearing". You do not trade with 100:1 leverage or 1%. Your margin required is 1%. If you go broke your broker will allow you to trade up to 100:1. Let me explain the problem with an example of half-percent margin. A prominent market maker offers "$1.000" lots and "$500" lots. You have $10.000 and you use 1% margin on the $1.000 lots. What's your percentage?
Write it down here ____or hold the thought. You make $300 Dollars on a trade and decide this is too easy. You arrange to pay the $10.00 fee and trade on 200:1 leverage or "$500 lots."
You have $10.300 and you now use 1% margin on the $500 lots. What's your leverage? Write it down here ______or hold the thought.
The total is $1.000, still only 10% of your capital accounrequired for margin, what's the problem?
The problem is that it is a false concept to express risk as a ratio of "margin required" to "capital on margin". It is an illusion that your risk was the same, yesterday and today.
Yesterday you traded $100.000, i.e. you levered your money 10:1 (for each one Dollar you have you trade as if you have ten). Today you traded $200.000, i.e. you levered your money 20:1 (for each Dollar you have you trade as if you have twenty). All it means is the time it takes for the guillotine to drop has been halved. You can be deceived by lots of $1.000 and risking "only 10% of your capital". You don't risk only /10th of your capital, you risk your capital 10 times.

Effective Leverage vs. Maximum Leverage

On one hand traders can exploit the maximum margin requirements that the broker-dealer provides, which can range from 100:1 to 400:1, but on the other hand we have the technical aspect of the mechanism. When asking what leverage you are using in your trading, you have to refer to the leveraged amount which you are effectively using to enhance your trading strategy.

The effective leverage is of paramount importance. There is nothing wrong in choosing the maximum level of leverage that the broker-dealer allows. What can put a trader in a dangerous situation is when the effective leverage comes close to the maximum displayed by the broker-dealer.

The effective leverage is calculated by dividing the value of open positions by the available balance of the account. In other words, the real leverage is the amount of capital you are really using compared to the amount in your account.

With a position worth of $20,000 (2 mini lots) and an account balance of $1,000, the real leverage is 20:1 (20.000/1.000 = 20). If this trade loses 50 pips, the account balance would go down by 10%. Remember, the pip value would be $2,00, multiplied by 50 pips, that is $100.

Should this loss happen, the real risk would increase with the next trade - now a loss of $100 is 11% of the account. This also means that the effective leverage rises even if the position size is kept the same, because the account balance is now lower. This is the typical dynamic of a losing spiral we mentioned when traders blow up their accounts - by doing the same, they lose more with each trade. This is because leverage increases each time.

To compound the issue, if the trader increases his/her leverage deliberately thinking in recovering losses faster, he/she is not acting in his/her best interest.

A leverage of 20:1 in a single position is quite high if we are to stay in the market for the long run. If our method is efficient in terms of consistency, then we can fine tune the leverage to get the maximum profit from it. This doesn't mean to exploit the maximum leverage offered by the broker-dealer, but instead, to use the maximum leverage that our method can sustain without the danger of a margin call.

For instance, you can have 5 open positions with an effective leverage of 4:1 each one. This way, you arrive at a leverage of 20:1 by adding 5 positions, and you will be eventually better protected with multiple positions over different currencies, than betting that leveraged amount in just one currency pair. The same leverage of 20:1 spread over several positions is a measure to diversify your risk.

How to bring this into practice will be discussed further when studying the development of trading systems and money management techniques. For now let's take one more step in the appliance of the mechanics you have just learned.