Margin Call – Everything You Need to Know
Avoiding a margin call is paramount no matter if you’re just beginning or a seasoned vet, but how do you do that? Read on to get a full understanding on what a margin call is and how you can avoid them.
Trading on Margin
The ability to trade with margin is an important part of every trader’s toolkit. Margin trading allows traders to greatly increase the profit from their trades, as well as create profitable opportunities and trading strategies that would otherwise not exist.
However, trading on margin also comes with some very serious risks and responsibilities that every trader needs to be aware of. One of the most important aspects of margin trading is the dreaded margin call.
Fortunately, we’ve been trading with margin for years and have some great tips for staying clear of a margin call, but first lets go over what a margin call is.
What Is a Margin Call?
A margin call occurs when the equity in a margin account falls below the maintenance margin ratio. The maintenance margin is set for different accounts, investors and asset classes, and can be adjusted by a broker when necessary.
When the equity ratio in a margin account falls below the maintenance margin, the broker will make a margin call, and demand that the account holder deposit additional equity until the maintenance margin is met. If the account holder fails to do so within the allotted time frame, then the broker will start liquidating the account holder’s positions until the maintenance margin is met.
While the account holder may wish to maintain the position in expectation that the price of the assets will increase, the broker will liquidate regardless of the current or expected future price.
Most margin calls happen when traders hold positions overnight on margin and the stock has a big gap down the next day. If you can’t deposit cash immediately then the broker is likely going to close your position out and if that isn’t enough to meet the margin call they can even close out other positions.
So how can you avoid margin calls?
Tip #1 – Use Hard Stop Loss Orders
The judicious use of stop orders can help you to avoid margin calls by cutting some or all of your losses before they reach a margin call trigger point. Stop orders allow you to dictate the means by which you maintain your equity margin on your account, which is superior to letting your broker make the decision.
A set of staggered stop orders for small portions of your position can ensure that your account is always meeting the maintenance margin, which means you will never face a margin call.
Now, this won’t prevent your form receiving a margin call if the stock gaps down overnight so if you are planning on holding a position overnight on margin, it is best to minimize the amount of margin you’re using. Not only is it bad risk management to have a lot of margin risk overnight, but the downside potential can be catastrophic to the point where you blow up your account.
I’ve heard horror stories of people losing six figures overnight and not having the money to cover the margin call. So when trading with margin, be smart and minimize you risk when necessary.
This leads us to my next tip, don’t hold positions overnight on margin!
Tip #2 – Don’t Hold Positions Overnight On Margin
For new traders or traders with smaller accounts, holding a position overnight on margin is just too risky and should be avoided at all cost. Stocks gap down on unexpected news everyday and if you are fully loaded on margin that loss will be greatly magnified.
While starting off in your trading career focus on using margin for only intra-day trading and if you want to hold something overnight, reduce your size until you are no longer using margin.
I’ve heard too many stories of traders blowing up accounts because of this very reason. So learn from their mistakes and avoid holding positions with margin overnight.
Tip #3 – Know Your Broker’s Margin Requirements
The margin requirements for almost all contemporary brokers are detailed, varied and often complex. Different asset classes, investor classes, account types and even securities within each asset class will have different maintenance margins and margin call rules.
Before you place any trade, be absolutely sure that you know the maintenance margin requirements that will apply, and then set your risk parameters accordingly.
While the basic concept behind a margin call is simple enough, the actual execution of a margin call is a complex and varied process.
Read the fine print that your broker offers on their margin call rules to fully understand exactly how your broker will operate a margin call in each of the asset classes that you trade in. If you don’t understand something then give your broker a call to get a better explanation!
Final Thoughts
Trading on margin is how day traders make a living but not using it responsibly can be the end of your trading career. Exercise caution and trade small until you learn the ropes and are confident in your abilities to trade on margin.
If you have any questions let us know in the comments below!