Risk Management 101

05 - Leverage and Margin Calls


As discussed in the previous section, leverage can get tricky and may lead to margin calls when you don't know how to manage it properly. This section illustrates more examples on the common mistakes beginners make when handling leverage and how to avoid margin calls.

Let's say you have a balance of $10,000, which is initially equal to your equity and usable margin. Without taking any trades yet, your used margin is equal to $0.00. In the course of taking trades, your used margin will vary depending on how much you risk on the trade and your account leverage, but you will not have a margin call for as long as you equity is greater than your used margin.

Once your equity falls below your used margin, your broker will give you a margin call, which basically means that you have to put in more cash to sustain your positions or close your account altogether.

In a trade example, let's say your broker has a 1% margin requirement and you trade 1 lot of EUR/USD. Since you have a mini account, your used margin or margin required is $100 per lot. With that, usable margin is now at $10,000 minus $100 or $9,900 and used margin is at $100.

If you buy 80 lots of EUR/USD, you would wind up with a used margin of $100 multiplied by 80 lots or $8,000. That way, your usable margin is now at $10,000 minus $8,000, which is $2,000.

If price doesn't go in the direction of your trade, you could encounter a margin call once price goes 25 pips against you. This is because your used margin of $8,000 at $100 per lot means that for every pip of movement in EUR/USD translates to $80 in profit or loss. With $2,000 in usable margin, a 25-pip move against you or 25 multiplied by $80 could wipe out your usable margin.

When that margin call happens, you would be out of the trade and take the $2,000 loss on your account. Once the trade is closed, your equity and balance will be at $8,000 for a total loss of 20% on your account.

Bear in mind that EUR/USD can move by as much as 50 pips per day so there's a good chance that risking a large chunk of your account with a tight limit for encountering a margin call is almost guaranteed to lead to a loss.

Another factor you have to consider when avoiding margin calls is the spread offered by the broker. So if the spread on EUR/USD is at 2 pips, then price only has 25 pips minus 2 pips in leeway before resulting to a margin call in the previous example.

When you open an account with a forex broker, you should make sure that you read the fine print concerning leverage and margin. Bear in mind that your open positions could be liquidated by the broker when your used margin exceeds your equity so you should be fully aware of how these situations are handled, depending on the terms and conditions of opening a trading account.

Another way to avoid the dreaded margin call is to make sure that you make use of stop losses when you set your trades up. You should determine a line in the sand wherein your trade will be invalidated, and base your position risk on that value. This will be discussed in the succeeding sections.