The retail Forex market would not be as robust as it is today if it weren’t for the concept of margin. Although the Forex market has existed for decades, it used to be only accessible by high net-worth individuals. Margin brought an end to this by allowing traders with little capital to make high value trades.
How margin works
For example, a currency pair is traded in lots, which is 100,000 units, so, you would need at least $100,000 to trade a currency such as the USD/JPY. With margin, though, the same trader can make the same trade with as little as $1,000. This is because margin allows you to trade with the broker’s capital after making a small initial good-faith deposit.
In the above example, the $1,000 you use as margin gives you access to the rest of the required capital to make the trade.
On the other hand, margin can have a steep downside because the losses are also enormous and can wipe out the entire account’s capital. Before the account balance is wiped out, though, the broker will make a margin call. It doesn’t necessarily have to be a phone call, which is what used to happen in the past, but it is now usually an email.
The margin call is made to request for a deposit into your account so that the margin requirement level is met. If you don’t make a deposit in time and the account balance continues to drop due to a losing trade, the broker automatically closes all your trades. By this time, the account balance is usually severely depreciated or even reflecting a negative balance.
How to avoid margin calls
Most traders have, at some point in their trading career, received a margin call, and we know it’s a very stressful situation to find yourself in. To help others avoid falling into the same situation, here are some tips on avoiding margin calls:
Always use a stop loss
Jesse Livermore, one of the most successful traders, said that you should hope your winning trades produce more profit and be afraid that your losing profits will create more losses. Most people do the opposite, hoping that losing trades will somehow turn in their favour, and they watch as the situation keeps getting worse and, in the end, the margin call. A stop loss ensures you cut your losses as early as possible and avoid any chance of a margin call.
Trade small lots
Huge risks may bring huge returns but also huge losses on the on the other hand. You should always try to keep the size of your lots small so that you don’t suffer major losses. The temptation is usually to make a huge profit from a few trades, but this is a risky path. A single bad trade with significant losses can exceed the profits you made from all your previous winning trades, so always remember to manage risk properly.
Select lower leverage
The higher the leverage used, the bigger the potential profits or losses. There are currently some brokers who offer as much as a 1000:1 leverage, which can be enticing but very risky. The CFTC took note of this danger and set limits to leverage at 50:1, but other Forex regulators don’t have the same reservations. It’s always safer to operate under a small leverage to avoid margin calls, even though the profits may not be as large.
What do you do when you get a margin call?
The margin call is intended to get you to deposit more funds into your account to prevent being stopped out, but I wouldn’t recommend it. The fact that you’re getting a margin call tells you that the trade isn’t getting better, and making a deposit is akin to hoping the trend will turn around.
If you make the additional deposit, the trade will either continue getting worse, and you will get another margin call, or it will take a very long time before you can just break even. It’s best, therefore, to use those funds to fund your next account and manage it more wisely – don’t throw good money after bad.