18. What is margin trading and why do we have margin calls?
Concept of Margin trading
Margin trading is originally a hedging financial arrangement, in which buyers and sellers provide “margin”, a certain amount of deposit, to guarantee the fulfillment of future contracts. Therefore, margin trading usually has a leverage effect, which means it will amplify the amount of capital you have. At present, many banks and brokers also offer leverage arrangement, so that investors can have a better use, in an efficient and flexible way, of their capital. Based on this trading method, a variety of financial products with “margin” trading have been invented, including futures, options, forex, and contracts for differences (forex, stocks, stock indexes, commodities, cryptocurrency, etc).
When investors trade on the trading platform (broker), they need not to put up the full amount of capital. They are only required to pay the deposit with a particular proportion by the total value of the contract they have, and the proportion usually ranges from 5% to 10%, as the guarantee for the fulfillment of the contract. Furthermore, the deposit can be subdivided into the initial margin and maintenance margins.
The initial margin refers to the amount that should be deposited at the time when contracts established; A Maintenance margin means the amount of margin that needed to maintain the position held.
Risk of a margin call
Losses occur when the price of the underlying asset moves against the investor’s position, and if the balance of the initial margin minus the floating loss is below the level of maintenance margin required, the investor will receive a “margin call”. A Margin call actually means that the investor’s account balance has fallen below the maintenance margin required level of the contract. From the perspective of fulfillment, the account balance may not withstand more losses from the relevant contract held, and if the investor cannot provide more margin to reach the required level within a certain period, or the balance has fallen below the minimum margin required level, the contract in the account will be forced to close out (liquidation).
Some trading platforms issue margin calls or change margin requirements on accounts in advance when market volatility increases or certain risky events are predicted. Essentially, the increase of a margin is a security measure to protect your investment, especially when markets are unusually volatile.
Investors can trade with a smaller fund size through margin trading, however, such flexibility also carries some risks. As a result, most skilled traders will put more money in for margin than the initial margin needed, reducing the chance of margin calls, which could force them to close out positions in times of sudden market volatility.
Next Article: 19. How to calculate leverage?
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Risk Warning: The above content is for reference only and does not represent ZFX’s position. ZFX does not assume any form of loss caused by any trading operations conducted by this article. Please be firm in your thinking and do the corresponding risk control.