Margin trading is one of the quintessential aspects of speculative trading, also known as day trading.
While margin trading is common to the forex or currency markets, trading on margin is applicable for any short term trading. Margin is available for day trading in different markets including futures.
It is important for the trader to understand how margin works, more importantly how it is calculated.
When a trader understands the concepts of margin trading, they are better able to manage the risks on their trade. After all, anyone who has dabbled with forex trading might have seen the dreaded margin call.
This happens when the trader opens too many positions, leaving their trading capital vulnerable to market movements.
Just about any forex broker that you trade with, offers to trade on margin.
Another common term you may come across is leverage. Both margin and leverage are interrelated. In some cases, they are interchangeably used as well. Broadly speaking, both margin and leverage refer to the same thing.
This article on margin trading in forex gives you insights into how margin works, how it is calculated. By the end of this article, the reader should have a better grasp of margin trading and the intricacies that come with it.
Margin trading is defined as trading on borrowed funds from your broker. In turn, the forex broker uses the funds you deposit as collateral.
Margin trading allows traders to trade using leverage. This enables them to control larger positions without having to invest the entire capital upfront.
Of course, it is up to the trader to decide if they do not want to use any margin.
When choosing so, the leverage is in a ratio of 1:1. Meaning that the trader takes on full responsibility for managing their positions.
This is not possible most of the time. Leverage is basically free money that traders can use. Hence, even large speculative traders use margin when available.
When used wisely, leverage is a great way to make large profits. Margin trading allows you to magnify your profits. As a result, it can help grow your trading account rather quickly.
However, when a trader does not fully understand how margin trading works, it can lead to losses.
Margin trading and risk management go hand in hand. Hence, even if you follow the various principles of risk management, without knowing the margin details, you are shooting blind.
Many forex brokers make it clear when signing up about the margin that you want to choose. While earlier traders could choose a margin ratio of as much as 1:1000, this has become regulated nowadays.
Hence, the typical margin levels are leverages of 1:100 or 1:200.
In places such as the United States, the margin is limited to 1:50. This tends to put off many traders, especially those with small capital that they are willing to risk.
Margin trading in forex can get complex due to the different terms and the calculations involved.
A very easy to understand example of what margin is can be inferred using a mortgage.
When you purchase a home, you generally do not buy it in full (unless you have very deep pockets). For the most part, a home buyer would initially pay a certain percentage of the purchase price.
If this initial payment was about 15% - 20%, then a bank would usually step in to finance the remaining 85% - 80% of the home’s purchase price.
While you technically own the house, it is still mortgaged to the bank. Meaning that you get full ownership only after you have paid in full, over the years.
The same concept applies in forex trading as well.
When you want to trade one standard lot, which is 100,000 units of the currency, you do not need to have $100,000.
On the contrary, you can use a capital of just $1,000. Then, depending on the margin amount required for the trade, the broker locks this amount for the duration of the trade.
The main risk with trading on margin is that if you are careless, you end up losing your invested capital, and at times even more.
Hence, margin trading is both risky, but at the same time essential for day trading. After all, a trader would not want to receive a margin call. This happens when your funds are running low.
A margin call, when not adhered to can result in the broker automatically closing out your positions, regardless of whether they are in profit or running at a loss.
One of the reasons why margins in forex are so confusing is because they are worded differently.
Let’s look at the terminology first.
Leverage of 1:100 means that the margin amount is 1%. In other words, to control a position of $100,000, the trader is required to have $1000.
The table below gives a quick summary of leverage and margin requirements.
In the above table, you may notice that as the margin requirement goes up, the leverage falls. Hence, there is an inverse relationship between margin and leverage.
This is rightfully so because margin gives you the amount you need to have as margin in percentage terms. On the other hand, the leverage ratio tells you how much margin is needed to control the preferred positions.
Hence, going back to the above example a 1:100 margin means that you need to post a margin of $1 to control $100.
Assuming that you had $100, then using a 1:100 margin, you can control in total a position of $100,000. To put this differently, it would mean that you can open and hold up to one standard lot (for EURUSD, as an example).
This means that you can trade for example 5 mini lots, or 5,000 units, and so on.
From an MT4 trading platform perspective, traders can also deduce their margin by looking at their trade tab window.
Here, you will typically see details as below. We also give a brief explanation of these terms:
- Balance: This is the actual balance on your trading account
- Profit/Loss: This number specifies the profit or loss in the same currency as your balance
- Equity: This is the sum of balance and equity. It shows the unrealized gains in your forex account
- Margin: This is the amount that is locked in by your broker as a margin. Dividing Margin/Balance gives you the leverage that you are using on your account
- Free Margin: Subtracting the margin from the balance gives you the free margin or the free funds on your account
- Margin Level: This is the ratio of the total equity to the margin amount. It shows how healthy your trading account is, in terms of margin. The formula is Equity/Margin x 100
The example in the screenshot above can be derived as below using the formula mentioned in the above points.
Note the importance of margin level when trading.
This is the level that is specified by your forex broker. When your margin level falls below the specified level, it triggers a margin call.
A margin call is something that traders want to avoid.
A margin call occurs when your margin levels drop below the broker’s specified margin level. For example, a forex broker has a margin level or stop out level of 50%. When your margin level drops below 50%, it triggers a margin call.
In the above example, you can see that the margin level is 33%. This occurs because the floating PnL is a negative $90,000.
Hence, if the forex broker had a margin level of 50%, it would trigger a margin call. Failure to top up funds to raise the margin level results in automatically closing out of your trades.
Margin levels exist because they allow traders to not become overly leveraged. There is a huge risk as you will end up owing money to your forex brokers.
These days, forex brokers set a margin level of 50% to ensure that your trading account does not go into the negative.
Before you start trading, it is important for the forex trader to read the margin terms from their forex broker. These terms specify details such as the margin levels which are essential for you when day trading the currency markets.
A margin account allows the trader to be exposed to larger positions than what they can afford. In other words, leverage is the end result of the margin.
Using leverage traders can open larger trades. This in turn allows them to make meaningful profits in the forex markets.
But at the same time, margin and leverage also raise the prospects of losing large amounts. This is the case with most traders. It usually happens when the trader does not have good knowledge about how margin works.
In fact, many traders don’t pay attention to margin in the first place. This recklessness can lead to unwanted margin calls. It can in turn result in the trader losing their entire trading capital as a result.
When opening a trading account, traders are often prompted to select the margin on their account. Many traders tend to ignore this, and they end up choosing the highest leverage ratio available.
However, if you believe that the margin you choose was too high or too less, you can write to your forex broker to have that changed. In some cases, you can change the leverage from your trading account profile as well.
Trading on forex margin is a double-edged sword. While it is good, it is also bad. Many traders in forex have made money trading on margin. And quite a few have also lost money trading on margin.
When the markets are extremely volatile, the margin is the difference between losing all your invested capital.
Below are some pros and cons of trading forex on margin and leverage.
|Pros of trading forex on margin||Cons of trading forex on margin|
|Margin trading allows you to make large profits if your trades end up in a profit||Margin trading can cost you a lot more money if your trades end up as a loss|
|Margin trading in forex allows traders with low capital to invest and speculate in the currency markets||Because the margin is borrowed money, there are financing costs for trades that are kept open overnight|
|Ideally suited for speculative and short term trading only||Margin trading can prove to be expensive if you want to invest (trade kept open for more than a month)|
|Margin trading allows you to diversify into different asset classes (forex, metals, and other CFDs).||Margin trading or leverage is by definition risky and hence requires astute risk management skills and knowledge|
As you can see from the above, there are both advantages and disadvantages to trading on margin in forex. Despite the risks of using leverage in forex, margin trading is unavoidable.
When used wisely, margin and leverage in forex is a great way to increase your returns. But the number of returns you generate will of course depend on how you manage your risk.
Traders may have heard about the one per cent rule. Which is not to risk more than one per cent of your trading capital on any given trade. This goes hand in hand with margin and leverage. Many traders misuse margins for the fact that they fall into the greed psychology.
The ability to make huge profits from just a few pip movements often makes traders ignore risk management principles.
However, now that you have an understanding of how margin works, you should be able to get a better grip on your risk management.