This is not investment advice. The information provided is for educational and informational purposes only and does not constitute a recommendation to buy or sell any financial product.
Variation margin is the daily mark-to-market payment that a leveraged position generates. If the position moves against the trader, the trader's equity falls, and the broker may issue a margin call. The margin call is a request to deposit more cash, close part of the position, or both. The trader who does not respond to the call is exposed to a forced close, and the forced close is the worst-case outcome of an under-funded margin position.
The sequence of events
The first event is the margin call. The broker's system detects that the trader's equity has fallen below the maintenance margin, and the broker issues a margin call. The call specifies the amount of cash required, the deadline for the deposit, and the consequences of non-response.
The second event is the trader's response. The trader has a defined period (usually 24 to 72 hours) to deposit more cash, close part of the position, or both. The trader who deposits the cash meets the call, and the position remains open. The trader who does nothing triggers the next event.
The third event is the forced close. The broker's system closes the position at the worst available price, and the loss is locked in. The trader is left with a smaller account and a worse view of the market.
The fourth event is the recovery. The trader has to assess the situation, fund the account with additional cash if needed, and decide whether to continue trading. The recovery is difficult, because the trader has to overcome the loss.
The cost of the forced close
The cost of the forced close is the loss on the position plus the fee. The fee is the broker's charge for the forced close, and the fee is usually a flat amount (€25 to €100) or a percentage of the position value. The fee is published in the broker's fee schedule.
The cost is usually larger than the trader expected. The forced close is usually at a worse level than the trader's stop, because the broker is closing at the worst available price, not at the trader's stop. The slippage between the trader's stop and the forced close is a real cost, and the slippage is usually a few percent.
The cost is also larger because the trader is forced to close the position at the worst moment. The recovery is not possible from the closed position, and the trader has to wait for a new opportunity.
The most common cause of the forced close
The most common cause of the forced close is under-funding the margin. The trader who puts up only the initial margin has no buffer for a gap, and the gap triggers the margin call. The trader who puts up the initial margin plus a buffer has a cushion for most gaps, and the forced close is less likely to fire.
The second most common cause is over-leveraging. The trader who takes a position larger than the account can support is exposed to a margin call on a normal fluctuation, and the forced close is the most likely outcome. The trader who sizes the position to the stop and the account, not to the desired return, is less likely to be force-closed.
The third most common cause is holding a position over a known event. The trader who holds a leveraged position over a weekend, a holiday, or a major news event is exposed to a gap, and the gap is most likely to trigger the margin call. The fix is to be out of the position over the known event, or to size the position to the gap risk.
How to avoid the forced close
The honest answer is to size the position to the gap risk, not the daily risk. A trader who sizes the position to a 20% gap on the position has a buffer for most gaps, and the forced close is less likely to fire. A trader who sizes the position to the initial margin alone has no buffer, and the forced close is the most likely outcome on the first significant gap.
The second answer is to hold a cash buffer in the account. A trader with a 20% cash buffer can meet a margin call without closing the position, and the position remains open. A trader with a 0% cash buffer is forced to close the position to meet the call, and the loss is locked in.
The third answer is to avoid holding a leveraged position over a known event. The trader who is in a leveraged position before a Fed meeting, an earnings release, or a major data release is exposed to a gap, and the gap is the most common cause of a margin call. The fix is to close the position before the event, or to reduce the position size to a level that can survive a large gap.
What to do if the forced close has already happened
The first step is to assess the damage. The trader should look at the loss, the fee, and the remaining account balance. The remaining balance is the trader's capital going forward, and the capital is the basis of the recovery.
The second step is to review the strategy. The forced close is a signal that the strategy is not sized to the trader's account, the trader's risk tolerance, or the trader's discipline. The trader should review the strategy, identify the failure mode, and fix the failure mode before resuming trading.
The third step is to fund the account with additional cash if needed. A trader who has been force-closed may not have enough capital to trade the strategy at the right size. The trader should fund the account with cash that is not needed for other purposes, and the trader should resume trading at a smaller size.
Related resources
Where to start
If you are using leverage, the most useful exercise is to calculate the buffer you need to survive a 20% gap on your position. Our broker comparison lists the margin policies and the variation margin procedure at each broker, which together tell you what the cash flow looks like before you open the position.