Each time a trader opens a position through an online broker (dealing company), the part of funds on his account becomes frozen. This part is called a security deposit and used for a guarantee 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 to hedge the current losses (temporary losses) of the opened positions which can turn into suffered losses if the position is closed at the current moment.
If a client does not have enough funds to cover the current losses, then so-called margin call takes place signaling that the account should be replenished. Otherwise, the position is closed automatically by the broker, resulting in real losses of the client. The current losses can be caused by an unpredicted rate movement, in the opposite direction of an opened position. For example, you have placed a long trade on the USD/JPY 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 begin to 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 face 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 a long USD/JPY position opened by one mini lot ($10,000 ) the size of security deposit will be equal to 10,000 / 50 = $200. If you had $1,000 on our account – $200 of them were frozen, $800 – at your 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, i.e. we face a choice: either to close the position that will result in $800 loss, or continue waiting. But the position is still open and the rate may turn to another direction bringing a profit. We still believe that a long position opening was a 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 desirable for the company. For this case the dealing companies hedge their risks, 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 the untouched part of your security deposit is left on your account which turns into free margin. For example, 30% of security deposit is a threshold amount - that means that when the 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 will be left on the account. Such an amount will not be enough even to open a position, so additional funds must be added to the account.
What rate movement must happen for margin call activation? Let’s say that the US dollar rate versus the yen was at 104.75/85 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 reevaluated 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 the margin call. As we have 1 position opened by a mini lot ($10,000), $200 is the amount of security deposit, $800 – 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 the margin call looks like this: USD/JPY 95.76/86. We see that the rate must fall by 900 points to induce the margin call. In practice, for such a huge rate adjustment a lot of time is required, so we are not likely to activate the margin call.
What would happen if we open a position by 4 mini lots instead of one (in the amount of $40,000)? Then the security deposit would total to $800 , free-margin - $200 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 the margin call would be 103.60/70. We see that in such a case, the rate movement slightly more than by 100 points would bring the margin call into action. Worth pointing out that 100 points price fluctuation during the trading day – it is an usual situation on Forex. This example shows that the bigger the amount of your opened positions, the fewer funds are left on your free-margin, the higher opportunity of getting the margin call. Take it very seriously!
From said above it can be concluded that for avoiding the margin call it is necessary to watch over all opened positions and close them in advance in order to minimize the losses if the trend changes to unfavorable one. To relieve the trader from permanent watching over quotations the “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 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 a trader you have to be afraid of the margin call very much, as its activation can make you 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 hedging possible losses and expectable gains!