Margin in Forex Trading, Explained
You may have heard the term "margin" being mentioned in Forex and CFD (Contracts For Difference) trading before, or maybe it is a completely new concept to you. Either way, it is a very important topic that you will need to master in order to become a successful Forex trader.
In this article, we will provide a detailed answer to the question "what is margin in Forex trading?", as well as how it can be calculated, how it relates to leverage, what a margin level is and much more!
What Is Margin in Forex Trading?
Margin is the collateral (or security) that a trader has to deposit with their broker to cover some of the risk that the trader generates for the broker. It is usually a fraction of a trading position and is expressed as a percentage. It is useful to think of your margin as a deposit on all your open trades.
The margin required by your Forex broker will determine the maximum leverage you can use in your trading account. Therefore, trading with leverage is also sometimes referred to as "trading on margin".
Every broker has differing CFD margin requirements and it is important to understand this before you choose a broker and begin trading on margin.
Trading on margin can have varying consequences. It can influence your trading outcome either positively or negatively, with both potential profits and potential losses being significantly magnified.
How to Calculate Forex Margin
Let's say a broker offers leverage of 1:20 for Forex trading. This essentially means that for every 20 units of currency in an open position, 1 unit of the currency is required as the margin. In other words, if the size of your desired Forex position was $20, the margin would be $1.
Therefore, in this example, the margin is equal to 1/20 or 5%.
To demonstrate this the other way around, if we knew that a broker required a margin of 10%, we could calculate that for every $10 we want to trade, we have to supply $1 of margin. In other words, in this example, we could leverage our trade 1:10.
**Please note: in Seychelles our maximum leverage is 1:1000
What Is Free Margin in Forex?
You should now be comfortable with what margin is in Forex trading, how it is calculated and its relationship with leverage. But what is free margin?
Free margin is the amount of money in a trading account that is available to be used to open new positions. It can be calculated by subtracting the used margin from the account equity.
You may now be thinking "What is the equity?!". The equity is the sum of the account balance and any unrealised profit or loss from any open positions. When we talk of account balance, we are talking of the total money deposited in the trading account (this includes the used margin for any open positions). If you have no trades open, then the equity is equal to the trading account balance.
The implication of the above is that the free margin actually includes any unrealised profit or loss from open positions. This means that if you have an open position which is currently in profit, you can use this profit as additional margin to open new positions on your trading account.
We can better understand the term free margin with an example.
Free Margin Example
Let's say we have a trading account with a balance of $1,000 and a CFD margin of 5%. We want to open a position which has a cost of $8,000. At the point of opening the trade, the following is true:
- Account Balance = $1,000
- Margin = $400 (5% of $8,000)
- Free Margin = $600 (Equity - Used Margin)
- Equity = $1,000
If the value of our position increases, giving us an unrealised profit of $50, we can ascertain the following:
- Account Balance = $1,000
- Margin = $400
- Free Margin = $650
- Equity = $1,050
The used margin and account balance do not change, however, the free margin and the equity both increase to reflect the unrealised profit of the open position. It is important to note that if the value of our position had decreased by $50 instead of increased, the free margin and equity would have both decreased by the same amount.
What Is Margin Level in Forex?
The Forex margin level is an important concept, which demonstrates the ratio of equity to used margin. It is shown as a percentage and is calculated as follows:
Margin Level = (Equity / Used Margin) * 100
Brokers use margin levels to determine whether Forex traders can take any new positions or not. A margin level of 0% means that the account currently has no open positions.
A margin level of 100% implies that account equity is equal to used margin. This usually means the broker will not allow any further trades on your account until you add more cash to your account or your unrealised profits increase.
Margin Level Example
Imagine you have an account balance of $10,000 and open a position which requires a margin of $1,000.
If the market moves against you and results in an unrealised loss of $9,000, your equity will be $1,000 (i.e. $10,000 - $9,000). In this circumstance, your equity is equal to your margin, meaning your margin level is 100%. This means that you will no longer be able to open any new positions on your account, unless the market turns around and your equity increases again or you deposit more cash into your account.
Continuing with this example, let's imagine the market keeps moving against you. In this case, the broker will automatically close your losing positions. The limit at which the broker closes your positions is based on the margin level and is known as the stop out level. The stop out level varies from broker to broker.
The broker will close your positions in descending order, starting with the largest position first. Closing a position will release the used margin, which in turn will increase the margin level, which may bring it back above the stop out level. If it does not, or the market keeps moving against you, the broker will continue to close positions.
What is a Forex Margin Call?
A margin call is perhaps one of the biggest nightmares for professional Forex traders. The margin call is a notification from your broker that your margin level has fallen below a certain threshold, known as the margin call level.
The CFD margin call level is calculated differently from broker to broker but happens before resorting to a stop out. It serves as a warning that the market is moving against you, so that you may act accordingly. Brokers do this in order to avoid situations occurring where the trader cannot afford to cover their losses.
Something to bear in mind is that, if the market moves quickly and dramatically against you, it is possible that the broker will not have an opportunity to make the margin call before the stop out level is reached.
How can you avoid this unpleasant surprise? Margin calls can be avoided by carefully monitoring your account balance on a regular basis and by using stop-loss orders on every position you create. Another important action to undertake is implementing a risk management plan within your trading. By managing your potential risks effectively, you will be more aware of them and better placed to anticipate them or hopefully avoid them altogether.
Conclusion
You should now have an answer to the original question of 'what is margin in Forex trading?', as well as understanding how it is calculated and some of its associated terms - such as margin level.
CFD margins are a hotly debated topic. Some traders argue that too much margin is very dangerous and it is easy to see why. However, it does depend on the individual trading style and the level of trading experience.
Trading on margin can be a profitable approach to Forex and CFD trading, however, it is crucial that you understand all the associated risks. If you choose to trade using CFD margin, you must ensure you understand exactly how your account operates. Be sure to read the margin agreement between you and your selected broker carefully, if something is not clear to you, you should ask your broker to clarify.
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This material does not contain and should not be construed as containing investment advice, investment recommendations, an offer of, or recommendation for, any transactions in financial instruments. Please note that such trading analysis is not a reliable indicator for any current or future performance, as circumstances may change over time. Before making any investment decisions, you should seek advice from independent financial advisors to ensure you understand the risks.
