One of the most unpleasant experiences a trader can face is known as a margin call. To understand the dynamics behind this feature one must first appreciate what margin is in the forex market which unfortunately is a commonly misunderstood concept. The forex market is exciting and accessible to small retail traders because of the industry’s high leverage options. Leveraging a position involves putting down collateral known as margin, to take on a position that is larger in value.
The margin in a forex account is often referred to as a performance bond, because it is not borrowed money but only the amount of equity needed to ensure that you can cover your losses. In most forex transactions, nothing is actually being bought or sold, only the agreements to buy or sell are exchanged, so borrowing is unnecessary. Thus, no interest is charged for using leverage. So if you buy $100,000 worth of currency, you are not depositing $2,000 and borrowing $98,000 for the purchase. The $2,000 is to cover your losses.
A margin call is a broker's demand on an investor using margin to deposit additional money or securities so that the margin account is brought up to the minimum maintenance margin. Margin calls occur when the account value depresses to a value calculated by the broker's particular formula. An investor receives a margin call from a broker if one or more of the securities he had bought with borrowed money decreases in value past a certain point. The investor must either deposit more money in the account or sell off some of his assets.
A margin call typically arises when an investor borrows money from a broker to make investments. When an investor uses margin to buy or sell securities, he pays for them using a combination of his own funds and borrowed money from a broker. An investor is said to have an equity in the investment, which is equal to the market value of securities minus borrowed funds from the broker. A margin call is triggered when the investor's equity as a percentage of total market value of securities falls below a certain percentage requirement, which is called the maintenance margin.
If we combine all the causes of the margin call together into a list, the main reason that leads to the margin call is the use of excessive leverage with insufficient capital whilst holding onto losing trades for too long when they should have been cut. In forex trading, you can never be so sure; but most often than not, a margin call is detrimental to a trader. It is important that traders understands the causes of a margin call, so that they would know how to stay away from it.