Each time when a trader opens a position by means of on-line broker services (dealing company), the part of funds on his account is frozen. This part is called a security deposit and used for guarantee submission of that a trader will never lose more than he has on his account. Unblocked funds are called free margin and can be used for opening new positions. But it is not recommended to use all balance amounts to open positions, as free margin is also needed for backing up the current losses (temporary losses) of the opened positions which turn to suffered losses if the position was closed at the current moment.
If the client does not have enough funds for covering the current losses, then so called margin call takes place signaling about that the account should be replenished. Otherwise, the position is closed automatically by the Internet broker, the client bears real losses. The current losses can be caused by unpredicted rate movement, opposite to the opened position direction. For example, you have opened a long position with the US dollar at USD/JPY quotation and the dollar began falling. It does not mean that you will suffer losses, because at a certain moment the rate can reverse and the US dollar will move upwards again. But if at some moment of the dollar rate downturn against the yen there will be not enough funds on your account to resist the present losses – your position will be automatically closed and you will meet real losses.
The account balance is divided into security deposit and free margin. The size of security deposit depends on the leverage size provided by the dealing company (see the previous article), the lot types which the trader works with and the number of such lots. With 1:50 leverage and long USD/JPY position opened by one mini lot (10 000 USD) the size of security deposit will be equal to 10 000 / 50 = 200 USD. If we had 1 000 USD on our account – 200 of them get frozen, 800 – at our disposal.
From the moment of opening a position the current profit and losses are calculated, as the dollar rate against the yen fluctuates constantly. Imagine that the current losses amounted to 800 dollars, i.e. there has come such moment when if we close the position our loss will reach 800 USD. But the position is still opened and the rate may turn to another direction bringing a profit. We still believe that a long position opening was right decision. But the dealing company realizes that if the current losses exceed our account balance then it will have to handle the deficit by means of its own money that is certainly not suitable for the company. For this case, the dealing companies’ hedge, so as soon as your operating expenses cover a certain part of your security deposit – margin call is activated and all your opened positions are closed automatically. Only untouched part of your security deposit is left on your account which turns into free margin. At the picture is shown an example when 30% of security deposit is a threshold amount. That means that when margin call is active, only 70% of your security deposit is left on your account. In our example with margin call at a long dollar position 0.7 * 200 = 140 USD will be left on the account. Such amount will not be enough even to open a position, so additional funds must be added to the account.
What rate movement must take place for margin call activation? Let’s say that the US dollar rate versus the yen was at 104.75/85 by USD/JPY quotation at the moment of opening the position. In other words, we bought the dollars for 104.85 yens per dollar. The position is closed by a reversing deal, i.e. dollar is sold for yens and the profit/loss is revalued in dollars. Suppose that the spread size is fixed (10 pips) and we are interested in such quotation USD/JPY X/(X+10), which will cause margin call. As we have 1 position opened by a mini lot (10 000 USD), 200 USD is the amount of security deposit, 800 USD – free margin, so we get the following equation:
10 000 * (104.85 – X) / (X + 10) = 800 + 0.3 * 200
It turned out that X=95.76. So, the quotation which activates margin call looks like this: USD/JPY 95.76/86. We see that the rate must fall by 900 points to induce margin call. In practice, for such a huge rate adjustment a lot of time is required, so we are not likely to activate margin call.
What would happen if we open a position by 4 mini lots instead of one (in the amount of 40 000 USD)? Then the security deposit would total to 800 dollars, free-margin - 200 USD and our equation would be the following:
4 * 10 000 * (104.85 – X) / (X + 10) = 200 + 0.3 * 800
In this equation X would be equal to 103.6. So the quotation which activates margin call would be 103.60/70. We see that in such case, the rate movement slightly more than by 100 points would bring margin call into action. Worth pointing out that 100 points price fluctuation during the trading day – it is an usual situation at Forex. This example shows that the bigger is amount of your opened positions the fewer funds are left on your free-margin, the higher opportunity of getting margin call. Take it very seriously!
From said above it can be concluded that for avoiding margin call it is necessary to watch over all opened position and close them in advance in order to minimize the losses if the trend changes to unfavorable one. To relieve the Internet trader from permanent watching over quotations – “limit order” option was introduced. By means of it you will be able to specify threshold values for current losses when opening a position (stop-loss) and current profit (target, take-profit). As soon as the current profit and losses overcome threshold amounts – the position will be closed automatically. Unlike to a market order which comes as an order to open or close a position at current market rates, limit orders restrict your loss risks and your expectable earnings.
In summary, as an Internet trader you have to afraid of margin call very much, as its activation can make you a bankrupt. For this reason try to avoid situations when a big part of your account is frozen for a security deposit and keep watch over your free-margin to be enough. Do not try to open positions for all free funds on your account and use limit orders for restricting possible losses and expectable gain!