Margin in forex might be a hassle to unravel for there are so many things to learn about it. This article will answer all questions you have about it in a simple way.
What is margin in forex? And why it's important for your trading activity?
Understanding margin is not something traders can ignore. But, when we talk about margin, there is more than that meets the eye.
- What is Margin in Forex
- How Do You Calculate Forex Margin Requirement
- Relationship Between Leverage and Margin Requirement
- Free Margin vs Used Margin
- What is a Margin Call
- How to Avoid Margin Call
- Risk and Rewards of Using Margin in Forex Trading
What is Margin in Forex
The term margin is often mentioned in forex trading. Iit's not a new concept. However, novice traders might not fully understand the meaning of margin.
Margin in forex is not the cost or fee you pay in order to trade. It's the collateral that you (as a trader) need to have in order to cover some risk you generate for the broker.
Usually, margin is a fraction of trading positions and expressed in a form of a percentage.
The amount of margin you have can influence your trading outcome with significant differences in profits and losses.
For example, say a broker required a margin of 10%. That means every $10 you want to trade, you have to supply $1 of margin. In this case, we could leverage our trade to 1:10.
Some brokers conveniently offer interest on margin for their clients. That's why it's important to understand the forex margin requirement before choosing a broker.
How Do You Calculate Forex Margin Requirement
By using margin in forex, it means you have to calculate your margin requirement. It is different according to what pair of currency you are staking a position in vs the currency you used in your account.
For example, you are trading GBP and USD, while your account currency is USD. You decide to take a position with 10,000 units of currency.
This means you are buying 10,000 GBP (the base currency) against 100,000 USD (the quote currency). Since your account currency is USD, it means your broker will calculate the margin requirement in USD.
You need to calculate your margin requirement in GBP/USD. You can use this formula to find out.
(GBP/USD exchange rate) x contract size x % leverage x 100
Say the exchange rate of GBP/USD today is 1.38, your contract size is 1000, and your broker uses a leverage of 1:200 or 0.5%. Your forex margin requirement will be.
1.38 x 200 x 0.5% x 1000 = 1656
To save you some time, you can use a margin calculator to find out how much is your margin requirement per trade.
The Relationship between Leverage and Margin
When trading with margin, you need to be careful with leverage as well. The higher the leverage, the smaller the margin. It will automatically lead to a condition where you trade with great risk exposure.
For example, if you choose high leverage that means you can lose all of your money instantly because even small price movements can bring you big losses, provided the price is moving against your trade. In many cases, high leverage is also responsible for the urge to overtrade as it can reduce the margin requirement. For some rookie traders, it creates the illusion of having a big amount of equity at their disposal.
Free Margin vs Used Margin
Free margin is the amount of money in your trading account you can use to open new trading positions. The amount of your free margin can be subtracted from your account equity.
Side note, equity is the sum of your account balance and any unrealized profit or loss from any open positions. If you aren't holding any position, then all the balance in your account can be considered as the free margin.
Suppose you have a $10,000 margin with $50 unrealized profit, but you use $4000 to open a position. That means your free margin is $6000. You can use this money to open another position or keep it in your account. This makes your equity $10,050.
New traders might not know the difference between used margin and free margin. Used margin is margin itself. The amount of used margin can be seen from your capital and leverage ratio. For example:
Suppose you trade 1 standard lot with a $100,000 contract value. You open a position in EUR/USD with 1:100 leverage at the price of 1.1071. To calculate the used margin, use this formula.
Used margin = (contract value) x (lot) x (margin %) x current exchange value
($100,000) x 1 x 1% x 1.1071 = $1,107.1
$1,107.1 is your used margin.
What is a Margin Call
It is not uncommon for brokers to initiate a margin call. But what is a margin call? And how does it affected margin in forex trading?
A margin call is a warning system from your broker that is activated when your loss reaches the amount of your equity. The broker will close part of the position until the margin requirement is met again.
So, how does it work?
Suppose you choose a $1000 margin as a security deposit with your broker. Suddenly your position in the market worsens and your total loss reach $1000, that's when your broker might initiate a margin call. They will instruct you to either deposit more money or close the position.
There are some things that might cause margin call:
Some traders who made hefty profits will get a boost of confidence, which is good. But those with bad money management might be tempted to open more positions carelessly.
This move can be a mistake that might lead to a margin call. Taking risk is allowed when you have a good analysis and trading strategy to execute it. But if you're not, then it's better to take a step back and revise your strategy.
The result of being overconfident is overtrading. When a trader opens a position based on emotion, they tend to ignore the market analysis. This might lead them to margin call and lose all the profits they make.
2. Trading Without Stop Loss
Trading without stop loss can be dangerous, especially for novice traders. If you let your trading positions closed with a considerable amount of loss, you might experience a cumulative margin call.
That means your losses will eat up your free margin and eventually leads to a margin call. In short, do not trade without a clear strategy and strong analysis.
See Also: Forex Brokers with Guaranteed Stop Loss
How to Avoid Margin Call
Now that you know about margin call, you might ask yourself 'how do I avoid it?'. There are few steps you can do to avoid a margin call.
1. Choose Major Currency Pairs
Major currency pairs have low spreads and high liquidity. This makes them easier to be analyzed with minimum extreme volatility. You should choose major currency pairs such as GBP/USD, USD/JPY, USD/CHF, and EUR/USD.
2. Risk Management
Managing risk is important if you want to avoid a margin call. That means you have to be aware of the available fund in your trading account. Then, make realistic movements to prevent your losses.
3. Manage Your Emotion
Emotion can be influential when using margin in forex trading. If you want to avoid margin call, you can't be overreacting when you lose a trade. Keep your emotion in check. If you don't, it might lead to overtrading and increase the risk of margin call.
4. Learn from Mistakes
As bad as it sounds, most traders have experienced margin call. What you need to do is to avoid repeated margin calls by continuing to evaluate your trading style. It might seem trivial but it is helpful to monitor your journey and trading progress.
5. Hedging Strategy
Learning about hedging strategy can be useful to avoid margin call. You can do this by opening two positions in opposite directions simultaneously.
Let's say your Buy position is losing because the price keeps declining from your entry point. Consider opening a Sell position on the same pair. The main idea is to offset the amount of loss you get from your Buy position.
Make sure to take notes of the correlation between currency pairs. It very dangerous if you misunderstood the correlations and will eventually lead to cumulative margin calls.
Risk and Rewards of Using Margin in Forex Trading
While it's true that using margin in forex might amplify the risk, the rewards can be just as big.
The risk of using margin in forex might expose your account to significant losses. Not to mention the stress you get due to the implications of market volatility. Don't forget that your account can be subject to a margin call as well.
Nonetheless, using margin in forex trading is undeniably effective to grow your account value more exponentially.
There are several misconceptions about trading with margin. Are they real or just myths? Find more about them here.