Margin, leverage, margin calls, equity, and all the rest of them fancy words that you might mix up from time to time. Perhaps you have heard from your trader friends that a margin call is really bad. In fact, a margin call is when the broker notifies you that you have exceeded the amount of loss with respect to your own equity.
Basically, it means you have lost more than you can make up for. This is when the broker will quite literally call on you to either stop or put up more equity to be able to continue.
But there are many important concepts that are related to each other and that you need to know in order to avoid getting a margin call.
But to find out the real solution to that, we first need to discuss leverage and margin.
What Is Leverage Trading in Forex?
It all starts from leverage. The idea of leverage can sort of be found in its name. It provides you with a leverage to pick up a heavier load in the market, when in fact your initial power was not enough to pick it up.
But who provides this leverage? Your forex broker of course.
Depending on your broker the amount of leverage can be different. Well, it is not an amount exactly. It’s a rate or a percentage. A percentage of your initial equity that you bring to the table.
For instance, there is a usual leverage rate of 1:30 in the brokers that are registered in the European Economic Zone and are bound by the constraints put in place by the legal entities in this area.
This means for every dollar you put in your account you can trade with 30 times more than that. So if you want to trade 30,000 dollars but only have one grand. Then you can put in that one grand and with leverage, you will get 30 grand instead.
But there are other brokers that offer even higher rates of leverage. For example, 1:400 which means for example if you have $50,000 initially, you can use this leverage and trade $20,000,000 instead. That is of course a stupendous amount of money. It means that if you know what to do, then your profits can also be stupendous.
So this is the definition of leverage and leverage trading. But why would traders opt to use leverage? Let’s find the answer to that question in the next section.
What Is the Purpose of Leverage Trading?
What Is the Purpose of Leverage Trading
The main purpose behind the use of leverage in the forex market or other markets for that matter has to do with cumulative profits.
The thing is if you start trading with a small initial equity, then the profits that you earn will be quite nominal. In that case, you need to depend on cumulative profits. After all, what is 2% of $1000, right?
But if you keep doing that a hundred times or even more, then your profits can accumulate.
But let’s face it, that will take a very long time. And it would only work if you were a truly skilled trader who didn’t make mistakes along the way.
So to circumvent this rather challenging situation, brokers have made it possible for traders to trade with leverage that they provide for them.
In this case, instead of making 2% on one grand, you would make 2% on 20 million dollars, for example.
But the other side of this glamorous deal is the losing side. If you don’t know what you are doing, then the losses can also be incredible.
But how much can you lose?
Would the broker allow you to lose their 20 million dollars?
You bet your life it wouldn’t.
This is where the ideas of margin and margin calling enter the situation.
What Is the Meaning of Margin in Forex?
The idea of margin goes hand in hand with the idea of leverage. The thing is that brokers do not just hand over hundreds of thousands or at times millions of dollars to you.
They need to protect their own interests.
The starting step in this protection is margin. Margin is the amount of money that traders are required to put to receive a certain rate of leverage.
Depending on the broker, the market, and of course the rate of leverage, the amount of margin can be different.
Margin is usually defined in terms of a percentage of the total leverage that you will receive.
For example, you need to put in 20% of the total leverage as your margin in order to receive the leverage.
This margin is actually locked in and you cannot pull it out anytime you want while you are trading with the leverage that broker has provided for you.
It kind of acts like a collateral.
So far, the situation was one in which everything went well. You come in with an initial equity. You put in that equity as your margin to receive leverage for trading. You start trading and earn manifold profits through the leverage. In the final analysis, you pull out with your initial equity and your manifold profits, and you also give back the broker’s leverage money in addition to a fee from the profits.
Win-win.
But what if you start losing money while trading with leverage?
What Is a Margin Call?
What Is a Margin Call
If you start losing while you are trading with leverage, that is when you get closer and closer to a margin call.
If you lose money, you will not actually lose the broker’s money. You start losing your own money first – the margin that you put in as the initial equity.
If you keep losing, your margin will eventually run out.
Imagine you have put in $5,000 and are not trading with a 1:20 leverage rate which equates to $100,000.
If you go into a losing position, then you start losing. You will be notified along the way how much you have lost.
But, in this example, if you lose as much as $5,000 then you will be margin called.
A margin call is a literal call or notification by the broker to the trader that the margin has run over.
They give you two options in this situation. First, you can inject more money into the position, thus providing more margin that can keep your position afloat.
And, second, if you do not act quick enough or if you don’t want to put in more margin, the broker will fully liquidate your position and take out their own money to protect their assets.
So in leverage trading, the broker will never actually lose money. The only person who stands to lose money is the trader.
How to Avoid a Margin Call?
Although there might be various tips and tricks out there telling you how you can avoid getting margin calls, the only sure fire way to avoid this unfortunate situation is to know how to trade.
Leverage trading provides a much higher chance of profiting for traders. But at the same time, it comes with a much higher chance of loss.
So to avoid margin calls, treat leverage with absolute caution.
Conclusion
A margin call is a notice given by the broker to the trader that their margin has run out in their position. This position is one that involves leverage provided by the broker. So the broker will notify you that your initial equity has run out. If you want to keep continuing the leverage trade, you need to put in more equity. If you don’t, then the broker will liquidate your position to take out their leverage.
