Formula for Margin Call: A Guide for Traders - The Profit Score

Formula for Margin Call: A Guide for Traders

What are Margin Calls

Margin calls are essential part of trading on margin. Trading on margin allows traders to borrow money from their broker to leverage their positions. In this way they can increase their buying power to a considerable extent. However, the increased buying power comes with its disadvantages as well by increasing the risk. Margin calls serve as a safeguard for both the broker and the trader.

When the value of the capital of a trader’s account falls below the specified agreed limit between trader and broker known as maintenance margin level, the margin call triggered. It means that trader either has to deposit more funds in the account or sell a certain level of securities to maintain the margin level. Failing to do so, the broker has the authority to liquidate the trader’s positions to cover his losses.

For example, if a trader has capital of $ 50,000 and the broker has provided the margin of 50% then the trader will have the power to purchase the stock worth of $ 100,000 where broker has provided the loan of $50,000. The option to utilize the borrowed capital also called leverage comes with certain requirements as follow.

Initial Margin: Initial margin is the percentage of minimum investment that a trader should contribute for a trade before taking position.

Maintenance Margin: It is the minimum percentage that trader must maintain in their account to avoid from margin call or to keep his positions open.

Margin calls happens when after taking the trades, the value of the equity deceases to a level that it cannot maintain the minimum maintenance margin. Don’t get confuse, we shall discuss it with the help of examples. The margin call can be tackled with two ways

  1. Deposit more funds in the trading account
  2. Exit some of the trading position 

Formula for Margin call

As a margin call refers to maintain the minimum equity percentage which is pre-defined and failing to do so result in margin call. The margin call price can be calculated with the help of following formula for margin call.

 

Formula for margin call

Formula for Margin call Example

For example, a trader has opened a trading account by depositing $50,000 in the trading account.

The broker has provided 50% margin which means now he has total $100,000 for buying the stock or equities.

The trader has decided to utilize the full leverage and buy the securities of worth $100,000. So,

Initial purchase price = $100,000

Now let’s assume that trader and broker signed the contract to maintain the minimum 25% maintenance margin to run the account and avoid margin call. So, let’s find out the margin call price with the help of formula for margin call

Margin call price = $100,000 (1 – 50%) / (1 – 25%)

Margin call price = $75,000

So, the account value should always be above $75,000 otherwise trader will receive a margin call.

The maintenance margin is calculated on the basis of market value of the securities and deduct the margin loan. In the above example, if the market value of the securities decline to $75,000 then investor equity will be S 25,000 as

Investor Equity = 75,000 – 50,000

= 25,000

In this case, there will be no margin call as the 25% maintenance level is still maintained.

Let’s continue this example further

Assume the value of securities further decline to $60,000. Now the investor equity will be $10,000 which are less than the 25% maintenance margin which is calculated with the help of formula for margin call.

Investor equity = 60,000 – 50,000 = 10,000

As 10,000/ 60,000 < 25% so margin call will happen in this case. To keep the maintenance level of 25%, the trader has to deposit $5,000 into the account.

As 15,000/60,000 = 25%

The importance of Margin in Trading

Before looking for extreme consequences, it is essential to see the importance of margin in trading. Margin accounts help traders to increase their trading power and hence maximizing their potential returns. With the help of margin account, they can take larger positions with smaller amount of capital that is increasing their profit potential.

But this amplifying profit opportunities also come with increased risk and losses. In case, traders use margin, they in fact borrowing money from their brokers. And trade with borrowing money comes with higher risks. It is essential to carefully understand the risk involved and have a solid risk management plan to avoid from any potential losses. Also carefully see and understand the formula for margin call to manage your positions accordingly in case they are not in the right direction.

The importance of formula for margin call

How Margin Calls Work

When a trader opens a margin account, he is supposed to maintain a certain level of capital in their account known as initial margin requirement.  This initial capital requirement is normally a percentage of total account value.

As trader takes positions, the value of the account fluctuates on the performance of the positions. If the performance is not in the right direction and the value of the account falls below the maintenance level, a margin call triggers. The maintenance margin level is usually lower than the initial margin level as depicted in the formula for margin call to allow the positions to fluctuate to a certain level.

Common Causes of Margin Calls

There are number of elements that may become the reason for margin call. Understanding these elements can help traders save themselves from the possible margin call from their broker. Below are the most common causes of margin calls.

1. Market Volatility

If you are trading in a highly volatile where price is showing a significant movement, then the value of the trades will vary significantly. And the movement in the wrong direction can trigger the margin call.

2. Over Leveraging

The risk of margin call is higher if you are taking the excessive leverage. Traders who use too much leverage than their risk tolerance level, they are more vulnerable to market fluctuations.

3. Lack of Risk Management

If the risk management strategies are not properly implemented then there is a great chance of margin call. Have proper stop loss orders and keep your position size small to save yourself from potential losses and hence from margin call.

4. Insufficient Capital

Traders should ensure that they have sufficient funds available in the trading account before taking any position. Through this way they can give some room to their position to fluctuate without any risk of margin call.

You should be aware of these common causes that can lead you to face the margin call and avoid them from happening.

The impact of margin call on trader

The Impact of Margin Call on Traders

Margin calls have a significant impact on traders both emotionally and financially. If not proper managed, the margin calls may result in substantial losses. If margin call triggers and trader do not have enough capital to deposit, they may be forced to sell the securities at unfavorable price and time.

If we look at it emotionally, then margin calls can be very stressful and overwhelming. In case of margin call, trader may face emotional imbalance, fear and anxiety. These emotional imbalances can lead to poor trading decisions. So, it is important to stay calm and composed when facing a margin call.

Tips for Avoiding Margin Calls

There are several strategies that traders can use to minimize the likelihood of margin calls. Below are some tips to avoid the margin calls.

1. Self-Realistic Leverage Levels

Do not utilize excessive leverage and take only those positions that can be managed easily. Set the realistic leverage level as per your risk tolerance level which will reduce the risk of margin calls.

2. Monitor Account Value

Monitor and calculate your trading account value on regular basis and assess your margin requirements. By monitoring the account on a regular basis, you can take timely action in case there is a risk of margin call. See your trading account value in the light of formula for margin call and maintain the minimum level accordingly.

3. Implement Risk Management Strategies

Do not trade without proper implementing risk taking strategies. Develop these strategies as a part of your trading plan and follow these religiously. This will in turn minimize the risk of margin call.

4. Maintain Sufficient Capital

You should have enough capital available in your trading account to cover the possible losses and meet margin requirements. If you have enough capital available, then you can manage the risk effectively.

By following the above-mentioned tips, you can minimize the risk of margin call.

Margin Call Management Strategies

Along with tips for avoiding the margin calls, it is also essential to have strategies in place to manage the margin calls. Below are some strategies that can be consider in case of margin call.

1. Assess the Situation

First of all, evaluate the reasons for margin call and see its impact on trading account. Evaluating the right cause will solve most of your problems and help you to proceed in the right direction.

2. Communicate with Your Broker

Try to communicate with your broker and discuss the situation of margin call. The brokers normally have alternative solutions to get rid of this situation.

3. Review your Positions

Evaluate all of your open positions in the market and see closing of which positions can resolve the issue. Close those positions who are in major losses and may be the reason of margin call. Evaluate the formula for margin call and see which area needs improvement.

4. Learn from your Experience

Facing margin call is a learning experience. Evaluate the overall situation and causes of margin call and the ways you tackle the scenario. On the basis of this learning, improve your trading skills and risk management approached.

By following the above-mentioned plans, the traders can easily get rid of margin call situation.

Margin call management strategies

Margin Call Regulations and Requirements

Margin call rules and regulations vary across different countries and financial markets. It is important for traders to get themselves familiarize with the specific rules and regulation and the governing bodies of the respective countries that deal with these rules.

In case of the United States, the regulatory body is Securities and Exchange Commission (SEC). In United Kingdom, the regulatory body is Financial Conduct Authority (FCA). These regulatory bodies impose certain rules and regulations to protect the rights of the traders and brokers and maintain market stability. You should abide by these regulations to avoid from any penalties and legal ramifications.

Consequences of Failing to meet the margin call

If a trader’s account falls below the pre-defined maintenance requirements of margin account, then the trader may have to face the following consequences.

At first step, the broker will make the margin call and will ask the trader to deposit the additional amount required to meet the maintenance level.

If a trader is unable to deposit the additional amount, then the broker will ask him to sell the securities to avoid the shortfall.

Even failing to do so, the broker can sell trader’s securities at their own to increase the equity at trader’s account.

If the selling of the relevant securities cannot solve the problem, then broker has the discretion to close all the positions even without the consent of trader. Although this is taken as the last option. Through this way they can meet the minimum maintenance level of margin account. All the fees, and interest is charged to trader along with some extra fine in case inconvenience caused.

In case of failing the margin call, the brokerage firm also has the rights to close the entire portfolio and close the margin account as well.

Conclusion: Managing Margin Calls for Successful Trading

Margin calls are an essential element of trading on margin accounts and can have huge impact on trader’s financial and emotional well-being. By carefully understanding the formula for margin calls, see common causes, implementing risk management strategies and by managing the margin calls effectively, traders can navigate the volatile landscape of margin calls more confidently.

Do not forget that profitable trading requires a combination of knowledge, skills, discipline and adaptability. Stay tuned with the market and stay disciplined to stay ahead of the market. unlock the secrets of formula for margin calls and take your trading to the next profitable level.

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