5 Ways to Avoid a Margin Call
Trading on margin is a way for traders with limited capital to take on risks in an effort to make significant profits. Trading on margin is nothing but using leverage which is something that is common to the world of finance and investing. For example, companies take on more debt in order to finance their operations, which is no different from a trader using margin to day trade and control larger positions than what their capital could not normally afford. While margin trading has helped to lower the barrier for retail trading, it is still a dangerous weapon and warrants caution when trading.
Improper use of margin and leverage can result in a trading account going bust in a matter of minutes and in most cases it is because a trader either does not understand the concept or margin or fails to fund their account when presented with a margin call from their broker.
A margin requirement, as far as stocks are concerned is a percentage of the marginable securities that an investor has to pay with their own capital. The margin requirement for stocks (and futures and any financial trading instrument) is broken down into initial margin and maintenance margin. The initial margin is around 50% as per Regulation T and the maintenance margin is around 30% or higher depending on the security for stocks.
With futures, the margin requirements are similar but not as high in terms of percentage value. With futures trading, the initial margin amount and the maintenance margin is usually fixed per contract and determined by the exchange. Accessing this information is also as simple as heading to the CME Exchange website and browsing through the futures contracts.
When you trade futures or stocks or even forex, brokers and traders by extension must adhere to the initial margin and maintenance margin requirements that need to be respected at all times.
A margin call still allows you to keep your positions open and is only a warning by your broker. Failure to act upon a margin call and a further deterioration in the position can result in automatic closure of the open trades.
1. Understand what causes a margin call
Let's start with the simplest and easiest way to avoid a margin call!
Understanding margin call is the first step in knowing how to avoid one. Many traders tend to focus on other aspects of trading such as stop loss or entry price levels, but little thought is given to the other important elements such as margin requirements, maintenance margin requirements and so on.
One of the biggest reasons why a trader would be hit by a margin call is partly because of not knowing what causes a margin call and therefore allocating trade sizes without knowledge of margin requirements.
A margin call occurs when a trader's equity falls below the minimum maintenance margin requirement. It is simply the broker's demand for the investor to top up their account to meet the minimum margin requirements. Although most of this is now automated and you won't really be getting a call from your broker (unless you were trading like a hedge fund) you will receive text or email notifications alerting you to the margin call.
Every instrument or security that you trade on margin is subject to the initial margin, which is the collateral that you post to trade on margin and the maintenance margin that you must have in your account at all times to keep your position active in the market.
As mentioned above, for stocks the initial margin requirement can be 50% with a 30% maintenance margin. What this means is that for a trader with $5000 in trading capital, he can buy stocks with 50% margin, or stocks worth $10,000. However, the trader also needs to have money for the maintenance margin as well, which is 30%. In other words, when the price drops by 30% or more, the trader will be alerted to a margin call.
2. Know the margin requirements even before you place an order
The concept of margin call isn't thought about much by most traders, especially when they are placing pending orders with their broker. Depending on the type of brokerage you deal with and the order execution functionality, there are only a few brokerage firms that incorporate margin call functions right from the moment of placing a pending order.
Typically, traders tend to place an order with their broker and it remains open until the limit price is reached when it is executed or until the expiry time of the order (if it is a good for the day type of order). Generally speaking, when you place a pending order, the trading account is not affected in most cases as the order is open but pending execution, thus margin is not applied to such pending orders.
However, this exposes the trader and the brokerage firm to the risk of automatically triggering the orders and if the trader did not take care on their positioning of the trades, the executed orders would quickly result in a margin call. In order to avoid such situations, traders need to consider the margin requirements from the time they plan to place an order. This would mean that the trader has to account for the margin amount that will be deducted from their trading capital and locked in as collateral as well as having some additional funds so their trades can have some breathing space.
When managing multiple orders, especially when placed with different assets, it can get quite confusing and if a trader is not careful, all the orders could result in a margin call. The best way to avoid such nasty surprises is for the trader to effectively understand the margin requirements for the instruments they are trading or plan to trade, along with detailing other factors such as tick size, tick value, the contract’s value and so on. This way, a trader can have a better grip in the margin requirements and thus not risk other positions for a margin call as well.
3. Using trailing stops or stop loss orders to avoid margin calls
Trailing stops are one of the most effective ways to avoid getting a margin call. It is in fact better than a stop loss, unless you manually keep moving your stops every so often. In many cases, having a trailing stop or a stop loss order for that matter can help in limiting your losses and also protect your trading capital against potential margin calls.
A stop loss order is basically a stop order sent to the broker as a pending order. This order is triggered when price moves against your trade’s direction. For example, if you were long on AAPL at $100, you would set your stop loss at $95.00. This means that when AAPL's price falls to $95.00 your stop order is triggered and your long position is closed for a $5 loss. Now imagine trading without a stop loss order in this example and APPL's price continued to fall. Sooner or later, depending on the position size, your account would trigger a margin call.
A trailing stop on the other hand is more dynamic as it trails or moves your stops every time price moves a certain ticks in your trade's direction. A stop loss order not only protects your account again a margin call, but in many cases, it can also limit your losses by moving the trade to break even or when a trade progresses smoothly, a trailing stop order can lock in some profits as well.
When using stop loss orders or trailing stops, traders should bear in mind that the margin requirements remain the same. Meaning, if you were trading one lot in E-mini S&P500 futures, and the margin requirement was $500, then regardless of whether you use a trailing stop or a stop loss order, the $500 margin is locked in. You also need to have a healthy maintenance margin as well.
What the stop loss order or the trailing stop order does is prevent your trading from taking on further losses than what you have already specified, thus limiting the downside exposure that could lead to a margin call.
4. Use position scaling effectively to manage your trades
Misjudging the price action or the price movement is another reason why many traders end up with a margin call at some point. Second to this is falling for greed and taking on larger than expected risk on the trade by opening a big position. The prevailing narrative here is that the trader remains confident on their analysis and is tricked into taking on a big position to make profits quickly.
This is very tricky and can quickly turn a winning trade into a loser, leaving the trader holding the bag with some rather large unexpected losses, or even worse a margin call.
In order to avoid such instances, a trader can instead build positions in a trade, also known as scaling. So instead of trading with 10 contracts, you would rather start your trading with one or two contracts and scale in or add to the positions as and when price starts to move in your favor. While you continue adding new but smaller positions, you also start moving the stop losses on the older positions to break even.
When used effectively, position scaling can you help you nearly double or triple your profits while trading risk free when you combine all the positions. While this might mean that you will have to allocate more capital towards the margin requirements, the scaling of positions at different price points and stop loss levels means that your distributed risk taking on the trade is spread out thus limiting you against any possible margin calls.
However, bear in mind that using techniques such as position scaling is only as good as the methods involved and thus a trader must be familiar in using these tactics.
5. Acknowledge that trading is risky
It is surprising to find that when a trader is hit by a margin call or when they lose too much on a trade, they often end up surprised. This happens when a trader truly does not understand the risks of trading. It is often said that a good trader focuses on managing their risks, while bad traders focus on chasing profits. This might be clichéd but is the absolute truth when it comes to trading and investing.
It is only when a trader recognizes the risks of losing is when they start to take measures by means of knowing or understanding the securities for the markets they are trading as well as focusing more on developing their risk management strategies instead of focusing on the next winning trading strategy.
While most beginners to trading are at a higher risk of being hit by a margin call, even seasoned professionals are not immune to this. Margin calls are common during times of an exuberant market where the overall sentiment is to get a pie of the bull rally, while throwing caution to the air. The sudden market crashes tend to occur every now and then and this usually weeds out weak positions and traders who have not taken adequate measures to protect their trades or open positions.
Know that trading and investing is risky is essential as it keeps you alert at all times. A good trader usually does not give much room for complacency, which can be disastrous and could potentially wipe out years of hard work that went behind building a profitable equity. Interestingly though, despite repeated warnings, the risk factor is often lost in translation among beginner investors.
The above five ways should effectively help a trader to avoid getting a margin call but are by no means the only way to avoid a margin call. Paying attention to the markets one is trading along with familiarity with the broker and the instruments or securities being traded can equip a trader to deal with emotions and also knowing when to cut their losing positions. Small factors such as understanding the volatility in the securities, the market events that could be responsible for creating the volatility are just some ways for a trader to be able to better manage their trading equity.
Trading is all about risk management and the sooner a trade realizes this, the more efficiently they are able to manage the risks.