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Margin trading is a cornerstone of many speculative accounts. To achieve consistent returns, it’s critical to understand both the ins and outs of margin trading and the causes behind margin calls. This article explores the fundamental concept of margin calls, provides an illustrative example, identifies triggers, outlines the consequences when a margin call isn’t met, and gives pointers on how to cover margin calls and prevent them from occurring in the first place.
Key Takeaways:
Margin calls are demands from asset lenders, typically brokers, requiring traders to increase the collateral held in their margin trading accounts.
While margin trading can amplify profits, it equally elevates risk, making margin calls a protective mechanism that prevents traders from incurring losses exceeding their initial investments.
Avoid margin calls by practicing proper risk management, understanding margin requirements, using leverage wisely and regularly reviewing your positions.
A margin call is a demand from an asset lender, typically a broker, to increase the amount of assets held as collateral in a margin account. At its core, a margin call serves as a protective measure, acting as a safety net for traders and investors engaging in leveraged positions within financial markets.
Margin trading essentially allows individuals to borrow funds from a broker in order to trade larger positions than equity in their accounts would typically permit. While buying on margin can magnify potential profits, it equally elevates the level of risk involved. A margin call is a mechanism that prevents traders from falling into a position where they could incur losses exceeding their initial investment.
In more practical terms, a margin call occurs when a trader's margin account balance dips below the minimum threshold, called a maintenance margin, required to maintain open positions. This triggers a demand from the broker, insisting the trader deposit cash into their margin account to cover potential losses, or sell assets in the account to reduce the minimum maintenance margin requirement. The objective is to mitigate the broker's risk by ensuring that traders don’t accumulate debts beyond the value of their assets and collateral.
At their core, margin accounts for stocks, forex, futures and crypto are similar, with some minor differences. Even within the Bybit exchange itself, maintenance margin is calculated differently for its various trading products and margin modes. Therefore, if you decide to open a margin account, make sure to review the broker’s margin requirements and margin call processes so you can be familiar with how they operate.
To grasp the concept of a margin call more clearly, let's jump into an illustrative example using Bybit's USDT Perpetual contract.
Imagine you have 500 USDT in your trading account, and you decide to purchase 0.5 BTC (Bitcoin) at $30,000 on margin. If Bybit’s maintenance margin rate is 0.5%, then $75 of your account must be allocated toward keeping your 0.5 BTC trade open.
Maintenance Margin = Position Size × Position Average Entry Price × Maintenance Margin Rate
Maintenance Margin = 0.5 BTC × $30,000 × 0.5% = $75
If the trader starts with $500 in their account and the price of Bitcoin falls by $850.02 to $29,149.98, then the value of their trading account would fall by $425.01, leaving no excess equity to cover the maintenance margin. As a result, a margin call would be issued.
Failure to heed the margin call and allowing the account balance to remain below the margin maintenance requirement could have dire consequences. In such a situation, the broker retains the authority to liquidate the trader's open positions to meet the margin call, often resulting in a significant financial setback for the trader.
Below are several factors that can serve as triggers for a margin call. The best medicine for a margin call is avoidance, which we'll cover below.
But first, understanding the triggers is crucial for managing risk effectively in a margin account:
Market Volatility: Sudden and substantial price fluctuations in the assets you hold can lead to receiving a margin call. If the market moves against your position, it will cause spreads to widen and losses in your account equity, potentially pushing it below the maintenance margin amount.
Adverse Price Movements: If you pick the incorrect direction for a trend, your margin account is at risk of a margin call. As the market moves against your position, it erodes the market value of your account. If this decline surpasses the broker's prescribed limit, a margin call will be initiated.
Excessive Leverage: Overleveraging is one of the biggest pitfalls in margin trading. Using too much leverage and leaving too little room for price swings dramatically increases the risk of a margin call. Even the slightest price movements at high amounts of leverage can result in significant losses relative to your account balance.
Margin Requirements: Each broker sets specific margin requirements, indicating the minimum account balances needed to support open positions. Brokers can change margin requirements if market variability or a political event threatens to create significant volatility.
Risk Management: Ignoring risk management strategies — such as not setting stop-loss orders or adequately diversifying your portfolio — can increase the likelihood of margin calls. Some traders don't place a stop-loss, and when the market moves against their positions, significant losses and even margin calls can result.
When a margin call does occur, it’s typically the result of one or more of the factors discussed above. Avoiding margin calls will help protect your capital so you have enough margin to make a trade on tomorrow’s trend.
It's crucial to grasp that in the event of a margin call, the broker (or lender) can liquidate your open positions without requiring your authorization. This is a precautionary measure that you likely agreed to when opening a margin account. It serves to protect both you and the broker in times of market volatility, preventing a scenario in which your account's equity could dip into negative territory, potentially exposing the broker to losses.
The broker may allow you time to add additional funds to your account, or to decide if you want to close your positions. The key point to remember is that the broker already has a signed agreement from you stating that they can liquidate a portion or all of your open positions immediately upon a margin call.
To make things worse, if market prices are extremely volatile and trending against the general positioning of market participants, margin calls by the brokerage firm can make for even greater price volatility.
For example, if a downtrending market causes a lot of clients to receive margin calls, then liquidating those clients' positions will only add a greater imbalance of sellers. This influx further drives down the market, triggering another wave of margin calls for accounts that have recently depleted their margins.
This scenario can result in a nasty cycle that causes extreme pricing dislocations. One of the last times this occurred in the crypto market was during the COVID-19 collapse in 2020.
“Covering” a margin call means raising funds to bring the equity level back above the margin requirements, a critical step in preserving your margin account and preventing further losses. If you’re trading in a market or with a broker that allows you time to decide how to meet the margin call, you generally have three choices to make.
Following are the basic strategies for covering a margin call.
Deposit Additional Funds: The most straightforward way to meet a margin call is to deposit cash into your trading account. This replenishes your account balance, bringing it back above the required maintenance margin level.
Sell Assets: If you have other assets in your portfolio, consider selling them to raise the necessary funds. These assets could be outside of the margin account, but then you'd have to deposit the sale proceeds into the margin account, which may take too much time.
Close Positions: Another option is to close out some or all of your open positions in the account that has received a margin call. By doing so, you can free up capital and lower your margin requirements.
Remember that timely action is crucial when trading on margin. Failing to promptly address a margin call could lead to further losses or the liquidation of your positions by the broker.
Preventing a margin call is the ideal scenario for traders and investors engaged in margin trading. Following are some strategies to help you avoid a margin call.
Proper Risk Management: One of the most effective ways to avoid a margin call is to practice sound risk management. This includes setting stop-loss orders for your trades, diversifying your portfolio and using leverage conservatively.
Understand Margin Requirements: Familiarize yourself with your broker's margin requirements and regularly monitor your account balance. Ensure you maintain a cushion above the minimum required balance to account for potential market fluctuations.
Use Leverage Wisely (or None at All): Avoid excessive leverage. Higher leverage multiplies both profits and losses. Additionally, consider using lower leverage ratios.
Regularly Review Positions: Keep a close eye on your open positions. Create a custom-made alert at some comfortable level above the margin maintenance requirement. That way, if the alert triggers, you’ll have time to adjust your account positions before market losses trigger a margin call.
Failing to meet a margin call can have significant consequences for traders and investors.
Position Liquidation: If you do not promptly cover a margin call, your broker may liquidate some or all of your open positions to recover the funds required to bring your account balance back to the required level. This can result in substantial losses as positions are closed outside of your trading plan.
Debt Accumulation: Any losses incurred beyond the value of your account can potentially lead to a debt owed to your broker. Although some brokers offer negative equity protection, other markets and brokers do not. Therefore, irresponsible margin management could add to your debt levels, making trading a very costly endeavor.
The inability to meet the minimum maintenance margin margin can be financially detrimental. It underscores the importance of responsible trading practices, proper risk management and a thorough understanding of the margin requirements set by your broker to mitigate the risk of margin calls in the first place.
A margin call appears after market losses erode capital from a margin account, and is meant to protect both trader and broker. The best way to safeguard your account is to avoid a margin call by taking adequate risk management precautions before losses eat away at your equity.
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