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 the 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 meets the eye.
What is Margin in Forex?
The term margin is often mentioned in forex trading. It's not a new concept. However, novice traders might not fully understand the meaning of margin.
The margin in forex is not the cost or fee you pay to trade. It's the collateral you (as a trader) need to have to cover some risk you generate for the broker.
Usually, the margin is a fraction of trading positions and expressed as a percentage.
Your margin amount can influence your trading outcome with significant differences in profits and losses.
For example, say a broker required a margin of 10%. That means for 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.
Usually, the trading platform will show traders how much equity they have alongside their balance and free margin. Here is an example of where it is listed in the popular trading platform MT5. Click the 'Trade' tab, and this information will appear below the charts.
How Do You Calculate Forex Margin Requirement?
Using margin in forex 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/USD while your account currency is USD. You decide to take a position with 10,000 units of currency.
This means you buy 10,000 GBP (the base currency) against 100,000 USD (the quote currency). Since your account currency is USD, 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.
What is the Relationship between Leverage and Margin?
When trading with margin, you must also be careful with leverage. 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.
The relationship between margin and leverage is inverse. The required margin decreases as the leverage ratio increases, and vice versa. Higher leverage allows traders to control larger positions with less margin required, which means they can potentially make larger profits than their initial investment.
High leverage is often 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.
For example, if a trader has a leverage ratio of 1:100, they can control a position that is 100 times larger than their margin deposit. In this case, if they deposit $100 as margin, they can open trades worth $10,000.
That means traders can take more positions with less money. When things go well, borrowed money can increase the returns, but, if things go badly, traders could lose their trades much quicker.
If they aren't careful, they will get margin calls sooner than those using smaller leverage.
Free Margin vs Used Margin, What's the Difference?
You can use free margin to open new trading positions in your trading account. 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, all the balance in your account can be considered the free margin.
Suppose you have a $10,000 margin with $50 unrealized profit but 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 a used margin and a free margin. The used margin is the margin itself. The amount of used margin can be seen from your capital and leverage ratio. For example:
Suppose you trade one standard lot with a $100,000 contract value. You open a position in EUR/USD with 1:100 leverage at 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 affect 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 reaches $1000. That's when your broker might initiate a margin call. They will instruct you to either deposit more money or close the position.
Some things 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 risks is allowed when you have a good analysis and trading strategy to execute it. But if you're not, 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 ignore the market analysis. This might lead them to a margin call and lose all their profits.
2. Trading Without Stop Loss
Trading without stop loss can be dangerous, especially for novice traders. If you let your trading positions close with considerable loss, you might experience a cumulative margin call.
Your losses will eat up your free margin, eventually leading to a margin call. In short, do not trade without a clear strategy and strong analysis.
How to Avoid Margin Calls?
Now that you know about margin calls, you might ask yourself, how do I avoid it? There are a few steps you can take to avoid a margin call.
- 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.
- Risk Management
Managing risk is important if you want to avoid a margin call. That means you must be aware of your trading account's available funds. Then, make realistic movements to prevent your losses.
- Manage Your Emotion
Emotion can be influential when using margin in forex trading. If you want to avoid margin calls, 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 calls.
- Learn from Mistakes
As bad as it sounds, most traders have experienced margin calls. What you need to do is to avoid repeated margin calls by continuing to evaluate your trading style. It might seem trivial, but monitoring your journey and trading progress is helpful.
- Hedging Strategy
Learning about hedging strategy can be useful to avoid margin calls. 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 loss you get from your Buy position. Make sure to take notes of the correlation between currency pairs. It is very dangerous to misunderstand the correlations, eventually leading to cumulative margin calls.
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 also be subject to a margin call.
Nonetheless, using margin in forex trading is undeniably effective in growing your account value exponentially.
There are several misconceptions about trading with margin. Are they real or just myths? Find more about them here.