Chapter 11. Margin call

Every time a trader opens a position on Forex using the services of an Internet broker (dealing company), a part of the funds in his account is frozen. This part is called a security deposit and is used to ensure that the trader will never lose more funds than he has in his account. The unfrozen funds are called the free part of the account and can be used to open new positions. But using the entire account amount to open positions is highly discouraged, as the free part of the account is also used to maintain current losses (temporary losses) on open positions, which become incurred losses if the position is closed at the current moment in time.

So under what circumstances does a margin call occur? Let’s look at the figure.

The amount on the account is divided into the security deposit and the free part of the account. The amount of the security deposit depends on the amount of leverage provided by the dealing company (this was discussed in the previous chapter), the type of lots the trader works with and the number of such lots. In case of 1:50 leverage and a long USD/JPY position opened with one mini lot (10 000 USD), the size of the security deposit will be equal to 10 000 / 50 = 200 USD. If we had 1,000 USD in our account, 200 of them are frozen and 800 are at our disposal.

From the moment a position is opened, current profits or losses begin to be calculated, because the dollar/yen exchange rate is constantly changing. Let’s imagine that the current losses amounted to 800 dollars, i.e. the moment has come that if we close the position, we will incur a loss of 800 dollars. But the position is still open, and the exchange rate can turn in the opposite direction, bringing us a profit. We still believe that opening a long position was the right decision. But the dealing company realizes that if the current losses exceed the size of our account, it will have to pay for the losses incurred from “its own pocket”, and of course it will not go for it. Since currency rates on Forex can change rapidly, it is difficult to fix the moment when your current losses will amount to the exact amount on your account. Dealing companies are reinsured in this respect, so as soon as your current losses overlap a certain part of your insured deposit, a margin call occurs and all your open positions are automatically closed. Only the unaffected part of the insured deposit remains in your account, which turns into the free part of the account. Each Internet broker has its own rules regarding the amount of current losses resulting in a margin call. The figure shows an example where 30% of the insured deposit is the threshold. This means that when a margin call occurs, only 70% of the insured deposit remains in your account. In our example with a long position in USD, when the margin call occurs, 0.7 * 200 = 140 USD will remain on our account. This amount will not even be enough to open another position, so we will have to deposit additional funds into the account.

What exchange rate fluctuation must occur for a margin call to occur? Let’s assume that the exchange rate of the U.S. dollar to the Japanese Yen in the USD/JPY quote at the moment of opening a long position was 104.75/85. I.e. we bought dollars at the rate of 104.85 Yen per dollar. The position is closed by a reverse transaction, i.e. by selling dollars for Yen and recalculating the profit/loss into US dollars. Suppose the spread size is constant (10 pips), and we are interested in such a quote USD/JPY X/(X+10), at which the margin call occurs. Since we have one position opened with a mini lot (for the amount of 10 000 USD), 200 USD is on the security deposit, and 800 USD is the free part of the account, we have the following equation:

10  000  *  (104.85  –  X)  /  (X +  10)  =  800  +  0.3  *  200

From where we get that X is equal to 95.76. That is, the quote at which the margin call occurs should be USD/JPY 95.76/86. We see that the rate should fall by about 900 pips for the margin call to occur. In practice, for such a big change in the rate it should take quite a long time, so it is unlikely that we will get a margin call.

What would happen if instead of one mini lot, we opened a position with four lots (for the amount of $40,000)? Then the security deposit would be $800, the available funds on the account would be $200, and our equation would take the form:

4 * 10  000  *  (104.85  –  X)  /  (X +  10)  =  200  +  0.3  *  800

In this equation, X would be 103.6. That is, the quote at which the margin call occurs would be 103.60/70. We can see that in this case, a rate fluctuation of a little more than 100 points would lead to a margin call. It is worth noting that a 100 pips fluctuation during a trading day is a common phenomenon in Forex. This example shows that the larger the amount of your open positions and the less cash you have left in the free part of your account, the more likely you are to receive a margin call. Take this with a great deal of seriousness!

From the above mentioned, it may seem that in order to avoid margin calls it is necessary to constantly monitor all open positions and close them in advance to minimize losses if the rate changes in an unfavorable direction. In order to relieve the Internet trader from the necessity of constant monitoring of quotes, the term limit order was introduced. With its help you can specify threshold values for current losses (stop order, stop loss) and current profit (target, take-profit) while opening a position. As soon as the current profit or loss exceeds the thresholds, the position will be closed automatically. Unlike a market order, which is an instruction to open or close a position at current market quotes, limit orders limit your potential losses as well as your expected profit. These terms will be discussed in more detail in the Forex University section.

So, as an Internet trader you should fear margin calls like fire. After all, its occurrence can simply ruin you. Therefore, avoid situations when a large part of your account is frozen as a security deposit and make sure that there are always enough funds in the free part of your account. Do not try to open positions for all the funds in the free part of your account and use limit orders to limit possible losses and expected profits!