Margin in foreign exchange trading is a novel idea for numerous traders and is frequently misinterpreted. In simple terms, margin is the least amount of money needed to execute a leveraged trade and can serve as a valuable tool for managing risk.
Margin call, which is closely related to margin, is something that traders strive to avoid. Not understanding what margin is can be extremely expensive, which is why it's critical for forex traders to have a firm grasp of margin before making a trade.
Continue reading to learn more about using margin in forex trading, how to calculate it, and how to effectively manage your risk.
FOREX MARGIN EXPLAINED
Forex margin is a deposit made in good faith by a trader as collateral to initiate a trade. It is essentially the minimum amount required in the trading account to open a new position. This is typically expressed as a percentage of the notional value (trade size) of the forex trade. The broker "lends" the difference between the deposit and the full value of the trade.
FX Margin Example
Below is an illustration of the forex margin requirement relative to the full trade size:
Trade size: $10,000
Margin requirement: 3.33%
THE RELATIONSHIP BETWEEN MARGIN AND LEVERAGE
It's important to understand the concept of leverage before proceeding. Leverage and margin are closely linked because the more margin that is required, the less leverage traders can use. This is because the trader must fund more of the trade with their own money, reducing the amount they can borrow from the broker.
Leverage has the potential to generate large profits as well as large losses, so it's critical that traders use it responsibly. Keep in mind that leverage may vary between brokers and may differ across jurisdictions in accordance with regulatory requirements. The table below shows typical margin requirements and their corresponding leverage:
| MARGIN REQUIRED | MAXIMUM LEVERAGE |
|---|---|
| 50% | 2:1 |
| 3.33% | 30:1 |
| 2.00% | 50:1 |
| 0.5% | 200:1 |
COMPREHENDING FOREX MARGIN REQUIREMENTS
Forex margin requirements are determined by brokers based on the level of risk they are willing to accept (default risk) while adhering to regulatory restrictions.
Below is an example of the forex margin requirement for GBP/USD, listed under the heading "Deposit Factor":
Margin is often viewed as a fee that traders must pay, but it is not a transaction cost. Instead, it is a portion of the account equity that is set aside and designated as a margin deposit.
When trading with forex margin, it's important to remember that the amount of margin required to hold a position open is determined by the trade size. As the trade size increases, traders move to the next tier, where the margin requirement (in monetary terms) also increases.
Margin requirements may be temporarily increased during periods of high volatility or in anticipation of economic data releases that are likely to cause greater than usual volatility.
The first two tiers have the same margin requirement of 3.33%, but this increases to 4% and 15% in the next two tiers.
After understanding the margin requirement, traders must ensure that their trading account is adequately funded to avoid a margin call. One simple way for traders to monitor their trading account status is through the forex margin level:
Forex margin level = (equity / margin used) x 100
For example, if a trader has deposited $10,000 into their account and currently has $8,000 used as margin, their forex margin level will be 125, which is above the 100 level. If the forex margin level falls below 100, the broker typically prohibits the opening of new trades and may issue a margin call.
It's crucial for traders to understand their broker's margin close-out rule to avoid having their current positions liquidated. When an account receives a margin call, it must be funded immediately to prevent the liquidation of current open positions. Brokers do this to bring the account equity back up to an acceptable level.
FOREX MARGIN TERMINOLOGY
Equity: The balance of the trading account after adding current profits, subtracting current losses, and considering the cash balance.
Margin requirement: The amount of money (deposit) required to execute a leveraged trade.
Used margin: A portion of the account equity that is set aside to maintain existing trades on the account.
Free Margin: The equity in the account after deducting the used margin.
Margin call: This occurs when a trader's account equity falls below the minimum level set by the broker, triggering the immediate liquidation of open positions to bring equity back up to an acceptable level.
Forex margin level: This measures how well-funded the trading account is by dividing equity by used margin and multiplying the result by 100.
Leverage: Leverage in forex is a useful financial tool that allows traders to increase their market exposure beyond their initial investment by funding a small portion of the trade and borrowing the rest from the broker. Traders should be aware that leverage can result in both large profits and large losses.
WHAT IS FREE MARGIN IN FOREX?
Free margin refers to the equity in a trader's account that is not being used as margin for current open positions. In other words, it is the amount of cash in the account that traders can use to fund new positions.
Here's an example to illustrate this:
Equity: $10,000
Margin allocated to existing position: $8,000
Free margin = equity – margin on open positions
Free margin = $10,000 - $8,000
Free margin = $2,000
MANAGING THE RISKS OF MARGIN TRADING
When trading on a margined account, it's important for traders to know how to calculate the amount of margin required per position if this information isn't automatically provided on the deal ticket. Be aware of the relationship between margin and leverage and how an increase in margin requirements reduces the amount of leverage available to traders.
Use an economic calendar to monitor important news releases if you want to avoid trading during volatile periods.
It's considered wise to have a large portion of your account equity as free margin. This helps traders avoid margin calls and ensures that their account is adequately funded to enter high-probability trades as they arise.
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