Borrowing money from your broker can lead to a margin call during rapid declines in the market. A margin call can be a wake up call for margin traders and brokers are strict at upholding their margin maintenance requirements.
Margin call definition
A margin call is what happens when a trader who makes transactions with money borrowed from the broker incurs losses and falls below the required margin maintenance level set by the broker.
This requires the trader to either deposit more cash into the account to meet the threshold, or liquidate some of their positions to free up cash.
Why is a margin call important for traders?
- Keeping track of your margin maintenance level is important in keeping your positions solvent
- The broker has legal grounds against the trader if the violation of the maintenance level is not resolved
- To avoid a margin call, it is best to diversify your investments and always keep cash reserves at hand
- The broker may require you to sell all of your positions depending on the level of divergence between the account value and margin maintenance levels
Margin call in more depth
Margin calls happen when the value of a margin account falls below the margin maintenance threshold. This is a level of liquidity that is required by the broker if the trader wishes to continue trading on margin.
A margin call is most likely to happen during exceeding market volatility.
When a margin call happens, the trader will be required to do either of the following to meet the maintenance level once again:
- Deposit additional cash into their margin account
- Liquidate some or all of their positions to generate cash
- Transfer securities held in other accounts to the margin account
When trading leveraged positions, it is important to remember that leverage is created using the funds borrowed from the broker, who will need their funds back after a specified period of time.
When a trader ignores a margin call, they risk legal action from the broker, as well as the termination of their trading account.
To avoid such a scenario, it is important to keep additional cash in the account and review account activity regularly. Frequently adjusting your trading strategy and diversifying your holdings can go a long way in preventing a margin call from wiping out a vast majority of your investments.
Margin call example in forex
The risks of a margin call can be lower when trading forex, as the currency market is characterized by lower profit margins. However, the leverage offered by forex brokers is significantly higher than that of their equity counterparts.
If a trader who has invested $10,000 on margin and has a 20% maintenance margin, they are at risk of a margin call if the account value falls below $8,000.
FAQs on margin call
What can cause a margin call?
A margin call is a demand made by the broker to the trader to increase their cash holdings in the margin account. This happens when the value of the account drops below the margin maintenance level predetermined by the broker. The trader can deposit cash or sell some securities to meet the margin threshold and avoid legal action and account termination.
How long does the margin call last?
After a margin call, traders typically have 2 to 5 days to respond and get their account back to the required margin maintenance level. If the margin call goes without a response, the broker retains the right to liquidate all assets held by the trader.