Beginner's guide to margin calls in CFD trading

Beginner's guide to margin calls in CFD trading

Reading time: 9 minutes

Few phrases in the financial markets strike as much fear into a trader’s heart as ‘margin call’. Irrespective of the asset classes you trade – be that forex, commodities, stocks, indices, or bonds – it does not have to be this way, as long as you understand what it means and, importantly, how to avoid it.

First and foremost: What is margin?

Before you can understand what a margin call means, a solid grasp of what margin means in the CFD (Contracts for Difference) market is necessary.

You will find that many describe margin as a ‘good-faith deposit’; unfortunately, it has become a common industry phrase, but, in my opinion, it undersells what margin actually does. It is not a token gesture; it is collateral to cover potential losses on a trade, designed to limit exposure for both the broker and the trader if the trade moves strongly against the desired direction. So, in a nutshell, margin is collateral.

Another common misconception is that trading ‘on margin’ (or ‘margin trading’) means the CFD broker has loaned you the money to trade. If you take a step back and think about this, it would be impractical and a very poor way of doing business for the broker. The broker would need millions, if not billions! You must understand that you are trading derivatives with CFDs – you are not trading physical shares of a company – and that there is absolutely no loan, as all CFD trades are cash-settled transactions.

The key point is that leverage comes from margin, not a loan.

Margin & leverage: One cannot work without the other

We now know that margin is not a deposit; it is collateral that helps protect both you and the broker. Leverage, however, is a ratio that indicates how much ‘control’ you have relative to your upfront capital. Leverage ratios range from as high as 500:1 and 200:1 down to 1:1, though this depends on jurisdiction and regulation.

If you are trading with 200:1 leverage, for example, this means that for every US$1 you have in your trading account, you can effectively control a position of US$200. At 500:1 leverage, you can control a position of US$500 for every US$1, and so on. These are, of course, extreme examples of leveraged trades, and theoretically, it would only take a very small move against you to wipe out your entire account if you maxed out your leverage. This is the risk, and often why many describe leverage as a double-edged sword. While higher leverage can amplify gains, it equally increases losses.

You can calculate your margin requirement directly from your leverage ratio. So, if your account has a leverage ratio of 200:1, dividing 1 by 200 gives an initial margin percentage of 0.5%. Consequently, if your account equity is US$1,000, you can effectively control US$200,000 in active positions.

Let’s imagine you decide to trade a large position of about US$150,000, or 1 standard lot and 5 mini lots (1.5 lots).

First, can you trade this with your account using leverage on a US$1,000 trading account? Remember, to initiate a trade, you have to ‘deposit’ 0.5% of the notional amount, which in this case is US$750 (150,000 * 0.005). Therefore, yes, you could trade this position, but with US$750 of your account equity effectively locked away, you run the risk of the remaining usable margin (or ‘free margin’) of US$250 being quickly eroded, as the pip value would be around US$15 (the calculation is not shown here, but the FP Markets pip calculator provides a handy tool to calculate this). It would take about 16 pips of downside to trigger a margin call, where margin equals your account equity (that is, US$750).

What is a margin call?

This leads me nicely to the question of what a margin call is. Consider another example in which a trader has an account equity of US$20,000 and puts on a huge trade that ends up dropping the account’s equity to US$1,000, which equals the initial margin required to open the trade.

The trader’s account is now at a 100% margin level, calculated by dividing equity by used margin (1,000 / 1,000). This is the ‘margin call’ point, particularly for those trading on MetaTrader terminals. Those who have been in this position will know that, despite its name, the broker generally does not call to request additional funds; instead, part of the terminal turns red.

Now, assume the trade continues to move unfavourably and starts chipping away at the remaining US$1,000 account equity. Importantly, your used margin (US$1,000) will not change; instead, your running loss will continue to grow. As most brokers work with a 50% stop-out level, if your account equity continues to drop and hits US$500 (from US$1,000), the broker will automatically begin closing out your most unprofitable positions to prevent the account from falling into negative equity, which is theoretically where you could start owing the broker.

How to avoid a margin call?

The most obvious way a trader can avoid a margin call is not to overleverage. Without exposing your trading account to unnecessary risk, your losing trades will be small and contained. This can be achieved using a well-defined risk management approach, as well as a trading strategy with an edge and solid risk-reward, which should offset those losses with winning trades.

Beyond this, implementing a protective stop-loss order is another practical way to help safeguard your trading account. A ‘stop’ lets you set a predetermined level on the chart at which the order closes automatically. While slippage can affect this (you may get a different price than you expected due to the time between submitting your order and the broker executing it), it still caps potential losses at a manageable level. This is particularly important around high-impact news events or periods of low liquidity, when prices can gap sharply and a position that looked safely margined one moment can be uncomfortably close to a call the next.

Finally, avoid the temptation to add to a losing position to lower your average entry price; this is sometimes called ‘averaging down’. While it can occasionally work, it also means committing more margin to a trade that is already moving against you, which is precisely the opposite of what you want to do when trying to avoid a margin call.

Written by FP Markets Chief Market Analyst, Aaron Hill