Sunday, August 28, 2011

Margin Call Exemplified

Assume you are a successful retired British spy who now spends his time trading currencies. You open a mini account and deposit $10,000.

When you first login, you will see the $10,000 in the "Equity" column of your "Account Information" window.

Usable Margin

You will also see that the "Used Margin is "$0.00", and that the "Usable Margin" is $10,000, as pictured below:

Usable Margin = Equity - Used Margin

Your Usable Margin will always be equal to "Equity" less "Used Margin."
Usable Margin = Equity - Used Margin

Therefore it is the Equity, NOT the Balance that is used to determine Usable Margin. Your Equity will also determine if and when a Margin Call is reached.

As long as your Equity is greater than your Used Margin, you will not have Margin Call.
( Equity > Used Margin ) = NO MARGIN CALL

As soon as your Equity equals or falls below your Used Margin, you will receive a margin call.
( Equity =< Used Margin ) = MARGIN CALL, go back to demo trading

Let's assume your margin requirement is 1%. You buy 1 lot of EUR/USD.
Your Equity remains $10,000. Used Margin is now $100, because the margin required in a mini account is $100 per lot. Usable Margin is now $9,900.

10,000 USD Balance, 10,000 USD Equity, 100 USD Used Margin, 9,900 USD Usable Margin

If you were to close out that 1 lot of EUR/USD (by selling it back) at the same price at which you bought it, your Used Margin would go back to $0.00 and your Usable Margin would go back to $10,000. Your Equity would remain unchanged at 10,000.

But instead of closing the 1 lot, you (the adrenaline-junkie, chop-socky retired spy that you are) got extremely confident and bought 79 more lots of EUR/USD for a total of 80 lots of EUR/USD because that's just how you roll.

You will still have the same Equity, but your Used Margin will be $8,000 (80 lots at $100 margin per lot). And your Usable Margin will now only be $2,000, as shown below:

10,000 USD Balance, 10,000 USD Equity, 8,000 USD Used Margin, 2,000 USD Usable Margin

With this insanely risky position on, you will make a ridiculously large profit if EUR/USD rises. But this example does not end with such a fairy tale.
Let us paint a horrific picture of a Margin Call which occurs when EUR/USD falls.
EUR/USD starts to fall. You are long 80 lots, so you will see your Equity fall along with it.
Your Used Margin will remain at $8,000.

Once your equity drops below $8,000, you will have a Margin Call.
This means that some or all of your 80 lot position will immediately be closed at the current market price.
Assuming you bought all 80 lots at the same price, a Margin Call will trigger if your trade moves 25 pips against you.

25 PIPS!
Humbug! EUR/USD can move that much in its sleep!
How did we come up with 25 pips? Well each pip in a mini lot is worth $1 and you have a position open consisting of 80 freakin' mini lots. So...

$1/pip X 80 lots = $80/pip
If EUR/USD goes up 1 pip, your equity increases by $80.
If EUR/USD goes down 1 pip, your equity decreases by $80.
$2,000 Usable Margin divided by $80/pip = 25 pips

Let's say you bought 80 lots of EUR/USD at $1.2000. This is how your account will look if it EUR/USD drops to $1.1975 or -25 pips.

10,000 USD Balance, 10,000 USD Equity, 8,000 USD Used Margin, 2,000 USD Usable Margin

As you can see, your Usable Margin is now at $0.00 and you will receive a MARGIN CALL!
Of course, you're a veteran international spy and you've faced much bigger calamities.
You've got ice in your veins and your heart rate is still 55 bpm.
After the margin call this is how your account will look:

10,000 USD Balance, 10,000 USD Equity, 8,000 USD Used Margin, 2,000 USD Usable Margin

EUR/USD moves 25 PIPS, or less than .22% ((1.2000 - 1.1975) / 1.2000) X 100% and you LOSE $2,000!

You blew 20% of your trading account! (($2,000 loss / $10,000 balance)) X 100%


In reality, it's normal for EUR/USD to move 25 pips in a couple seconds during a major economic data release, and definitely that much within a trading day.

Oh we almost forget...we didn't even factor in the SPREAD!
To simplify the example, we didn't even factor in the spread, but we will now to make this example super realistic.

Let's say the spread for EUR/USD is 3 pips. This means that EUR/USD really only has to move 22 pips, NOT 25 pips before a margin call.

Imagine losing $2,000 in 5 seconds?!
This is what could happen if you don't understand the mechanics of margin and how to use leverage.
The sad fact is that most new traders don't even open a mini account with $10,000.

Because you had at least $10,000, you were at least able to weather 25 pips before his margin call.
If you only started off with $9,000, you would have only been able weather a 10 pip drop (including spread) before receiving a margin call. 10 pips!

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