What it means
When traders use leverage, they borrow money from a broker to control a larger position than their own cash would allow. The broker holds the trader's deposit as margin, which acts as a cushion against losses.
If losses eat into that cushion beyond a set limit, the broker steps in. Brokers usually monitor a ratio called the margin level, which compares the account's equity with the margin currently tied up in open positions.
At one threshold, the broker issues a margin call asking the trader to add funds. At a lower threshold, the liquidation level, the broker closes positions without further notice.
The closing is automatic and does not wait for the trader's agreement. Positions are normally closed starting with the largest losing ones, and it may happen in a fast-moving market at a worse price than expected, so losses can be larger than the trader planned.
The exact levels differ between brokers and products. Foreign exchange brokers often use a percentage of margin, while crypto exchanges that offer leveraged contracts may set a liquidation price for each position that depends on the leverage used and the maintenance margin.
Traders should read the broker's terms to see which rule applies to them. The practical lesson is to use less leverage than the maximum available, keep spare cash in the account, and know the liquidation level before opening a position.
Businesses that trade derivatives to hedge need the same discipline, since a forced closing can leave the underlying exposure unhedged. A related risk is that many traders share similar levels, so when the price reaches a cluster of liquidation points the forced selling can speed up the move.
This feedback is one reason prices on leveraged venues can fall or spike faster than the news alone would justify.
In practice
Real-world examples.
Example
A currency trader uses 20 times leverage on a position. A small move against her takes the account to the broker's stop-out level, and part of the position is closed automatically, leaving her with a loss and a smaller position. She realises that a move of only a few per cent was enough to trigger the closing.
Example
A crypto trader opens a leveraged position with a liquidation price shown on the screen. When the market moves sharply, the price touches that level and the exchange closes the position, and the trader loses the margin posted. A price that recovers an hour later does not bring the position back.
Example
A corporate treasury team uses futures to hedge commodity costs. The finance director keeps cash above the broker's requirements so that a sudden price move cannot trigger forced closing of the hedge.
Formula
Calculation
Margin level (%) = account equity / margin used x 100.
Suppose a trader opens positions that require $5,000 of margin. After losses, account equity is $2,500. Margin level = 2,500 / 5,000 x 100 = 50%. If the broker's liquidation level is 50%, the broker will begin closing positions now. If the broker's margin call level is 100%, the trader would have received a warning earlier, when equity was 5,000 x 1.00 = $5,000.Case study
Seen in the real world.
Northgate Imports is an illustrative, fictional company that hedged its currency exposure with leveraged contracts held at a broker. The finance manager funded the account with the minimum margin required to keep the cost down.
When an unexpected announcement moved the currency sharply, the account fell to the broker's liquidation level and the hedge was closed at a loss. The company's imports then became exposed to the exchange rate just as it moved against them.
In this illustrative case, the company changed its policy to hold a buffer of 50% above the minimum margin and to set an internal alert well above the broker's level. It decided that the small cost of holding extra cash was worth the protection. The treasurer also began testing how large a currency move the account could survive.
Watch out
Common mistakes.
- Using the maximum leverage available, which leaves almost no room before positions are closed.
- Assuming the position will close exactly at the liquidation level, when fast markets can cause it to close at a worse price.
- Confusing a margin call with liquidation, since the first is a warning and the second is the actual closing of positions.
Questions
People also ask.
What is the difference between a margin call and liquidation?
A margin call asks you to add money, while liquidation is the forced closing of positions when you have not or cannot.
Can I lose more than I deposited?
In some markets yes, if prices gap through the liquidation level and the position closes at a loss larger than the margin, though some brokers offer protection against negative balances.
How can I avoid reaching it?
Use lower leverage, keep spare cash in the account, and place stop-loss orders earlier than the liquidation level.
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