What is a margin call?

The words “margin call” may now be more closely associated with a Hollywood blockbuster starring Kevin Spacey, but understanding the nature of margin is just as important to us small-time traders.

Sure, if I get it wrong, I’m not going to break the Bank of England, but I can do some serious damage to my investment fund.

Most traders have very little understanding of margin. Even experienced investors, who’ve been trading on margin for years, will, when pushed, admit that it’s a pretty vague area.

Why?

Well, I reckon it’s for the same reason that most of us don’t really know how sausages are made. There’s a very real worry that if we know too much about what goes on at a sausage factory, we’ll put ourselves off our favourite dinner.

Don’t worry, I’m not about to post a spoiler about sausages, but I am about to lay down some facts about margin. There’s really no need to have our heads in the sand about margin requirements – if we understand margin better, we can use it more effectively, AND avoid any nasty margin calls.

What is margin?

Let’s say I fancy putting some money into tin cans (no, not literally – into a company that makes cans), so I decide to buy Rexam shares through my spread-betting account.

Now, Rexam shares are currently trading at 379p, but as a spread better, I won’t be paying anything like that to gain control of some.

I’m going to bet £5 / point on these 379p shares. With a 10% margin requirement on my trading platform, this is going to cost me just:

(379 @ £5) * 10% = £189.50

So, I only require £189.50 in my trading account to open this position. Of course, if I’m managing my risk properly, I should have considerably more than that – let’s say I’ve got £5,000 in my trading account before I place this trade. I put my £5 stake on Rexam, and I’ve still got £4,810.50 left to play with.

To get that kind of action from real shares, I’d need to buy 500 shares, and shell out £1,895.

The added risk associated with margined trading is because, if the value of those Rexam shares suddenly plummet – although I’ve only been required to stump up £189.50, I’m actually in to the value of £5 x 379p (the full £1,895). Of course, if they do suddenly plummet, I’ll have a stop loss in place to limit those losses.

When spread betting was a relatively new phenomenon, there were a lot of horror stories spread about, concerning huge bottomless losses, when traders had staked a few pounds and were suddenly thousands in the red. However, these days, most firms will automatically put a stop loss in place on a trade, say 10% away from your opening price, which instantly gives you some protection in case the markets make a sudden, dramatic move.

So, that’s the basics of a margined trade, but margin isn’t a static thing – there are things we can do to change our margin requirements, and there are things that the markets do that affect our margin …

Your broker and your instrument

Different spread-bet companies have different ways of calculating margin requirements. Some will automatically apply a stop limit at your margin level; some will adjust your margin requirement according to where your stop loss is placed (I’ll talk more about this in a moment).

When you open a new account, don’t expect margin to be calculated in the same way as it was with another company you’ve used – check first.

Margin also varies enormously according to the instrument that you are trading. This is based on the volatility and liquidity of the instrument, so you’ll be paying a higher margin on small-cap shares compared to something that’s inherently more stable, like indices.

How your trade can eat up margin

Most spread betters have a fair grasp on the concept of initial margin requirement, which is what we’ve been discussing so far.

Where many get caught out is variation margin – that creeping cost of a trade that’s going against you.

Let’s say that my Rexam shares have moved off in the wrong direction, and are now standing at 360p. So I’m sitting on a potential loss of £95 (i.e. 379 – 360 @ £5).

This £95 is going to be taken away from my available trading funds.

In addition to this, as the value of the shares has fallen, my margin requirement will have changed.

The margin requirement is now £180 (i.e. 360 @ £5 * 10%)

New margin requirement = £180

Plus, the variation margin that’s been taken away from my available funds …

Variation margin = £95

Total requirement = £275

Which is £85.50 MORE than the initial margin requirement I’d set aside for this trade.

So, if you don’t have that extra £85.50 sitting in your trading balance, you’ll face a margin call in order to sustain your position.

Of course, as I said earlier, if you’re staking £5 a point, I’d be pretty horrified if you didn’t have a spare £85 in your account! Provided you’re practicing sound money management, and only risking 2% of your fund on any one trade, margin calls shouldn’t be an issue. However, if you’re a really active trader, with lots of positions open at any one time, issues can crop up.

Affecting your margin requirement

Some spread betting platforms use an “orders aware” margining system. This means that the margin requirement is tied in with the stop loss level.

In this way, by tightening up your auto stop, you can release funds in your trading account.

Some will also require a greater margin if you increase your stop loss.

When you’re using a new platform, don’t assume that the margin calculation will be the same as the one you were using before.

As traders it can seem like an irritation to monitor these costs of positions as they move in and out of profit. However, it’s important to remember what the alternative is – i.e. getting a margin call, and potentially having your position closed down on you.

Margined trading gives us the luxury of being able to trade big moves, without tying up loads of capital, which means we can use the rest of our money elsewhere, getting it working harder for us. Plus, with spreadbetting, it means that we won’t be paying tax on our winnings. All, in all, the bother or calculating margin requirements seems a price worth paying.

Related posts:

What is margin? What is margin close out?