Using margin to trade Forex is a new concept for many traders, often misunderstood. Simply put, margin is the minimum amount required to make a leveraged trade and can be a very useful risk management tool.
The concept of a margin call (which traders try to avoid) is closely related to the margin. Not knowing what margin is can be extremely expensive, which is why it is essential for Forex traders to fully understand this concept before placing a trade.
Read on to learn more about using margin to trade Forex, calculate it and manage risk effectively.
WHAT IS THE FOREX MARGIN?
In Forex, margin is a bona fide deposit that a trader places as collateral to start a trade. Simply put, this is the minimum amount a trader needs in their trading account to open a new position. Margin is often expressed as a percentage of the notional value (size) of the trade. The difference between the deposited amount and the total trade value is “borrowed” by the broker.
Forex margin example
Here is an illustration of the margin requirement in Forex depending on the size of the trade:
Commercial dimension : $ 10,000
Margin requirement : 3.33%
The link between margin and leverage
Before proceeding, it is important to fully understand what leverage is. Leverage and margin are closely related. This is because the greater the margin required, the less traders will be able to leverage, as they will have to finance a larger share of the trade with their own funds and therefore borrow from the broker will be less.
Leverage has the potential to generate big profits AND big losses, which is why it is essential that traders use leverage responsibly. Please note that leverage may vary from broker to broker and jurisdiction to jurisdiction, in accordance with regulatory requirements. The traditionally applied margin requirements and corresponding leverage are as follows:
|MARGIN REQUIRED||MAXIMUM LEVERAGE|
UNDERSTANDING FOREX MARGIN REQUIREMENTS
Margin requirements are set by brokers and are based on the level of risk they are willing to take (default risk), subject to regulatory restrictions.
Here is an example of a margin requirement on GBP / USD under the heading “Deposit Factor”:
For traders, margin is most often associated with a commission they have to pay. However, this is not a transaction fee, but rather a portion of the funds in the account that is set aside and assigned as a security deposit.
When using margin, it is important to remember that the amount of margin required to keep an open position will ultimately be determined by the size of the trade. As the size of the trade increases, traders move to the higher end, which will have a higher margin (amount) requirement.
Margin requirements may temporarily increase during times of high volatility, as well as before the release of economic data which could cause a higher than normal level of volatility.
For the first two tranches, the margin requirement is 3.33%; this is then increased to 4 and 15% in the case of the two subsequent tranches.
After knowing the margin requirement, traders should make sure that their trading account is sufficiently funded to avoid margin calls. To easily monitor the status of their trading account, traders can refer to the margin level:
Margin Level = (Equity / Used Margin) x 100
Let’s say a trader deposited $ 10,000 into his account, of which $ 8,000 is used for margin. The margin level would be above 100, 125 to be exact. When the margin level is below 100, the broker usually prohibits the trader from opening new positions and initiates a margin call.
It is essential that traders understand the broker’s specified margin close rule to avoid liquidation of current positions. When a trader receives a margin call, he should immediately fund his account to avoid liquidation of currently open positions. Brokers send margin calls to bring the account back to an acceptable level.
FOREX MARGIN TERMINOLOGY
Capital : trading account balance after adding current earnings and subtracting current losses from the cash balance.
Margin requirement: amount (deposit) required to carry out a leveraged trade.
Used margin : share of the account reserved to keep the negotiations going.
Free margin: capital present in the account after subtracting the used margin.
margin call : occurs when a trader’s account shows a level below the acceptable level established by the broker, which triggers the immediate liquidation of open positions in order to bring the account back to the acceptable level.
Margin level: account provision indicator, calculated by dividing the capital by the margin used, then multiplying it by 100.
Lever : financial instrument that allows traders to increase their exposure to the market beyond the initial investment by financing a small part of the transaction and borrowing the rest from the broker. Traders should remember that leverage can lead to big gains AND big losses.
WHAT IS THE FREE MARGIN?
Free margin refers to the part of the trader’s account that is not associated with the margin used on open positions. Another definition is to say that it is the capital in the trader’s account that they can use to finance new positions.
We explain this concept through an example:
Capital : $ 10,000
Margin assigned to open positions : 8,000
Free Margin = Equity – Margin on Open Positions
Free Margin = $ 10,000 – $ 8,000
Free float = $ 2,000
MANAGING THE RISK INHERENT IN MARGIN TRADE
If you are trading on a margin account, it is crucial to know how to calculate the required margin amount per position if it is not automatically indicated on the trade ticket. Keep in mind the relationship between margin and leverage and that increasing the required margin reduces the level of leverage you can use.
Watch for important releases using an economic calendar if you prefer to avoid trading during times of volatility.
It is considered prudent that a large part of your account is free. This allows you to avoid margin calls and ensures that the account is sufficiently funded so that you can enter high probability trades as soon as they occur.
USEFUL RESOURCES TO IMPROVE YOUR PERFORMANCE
- If you starts in Forexfamiliarize yourself with the fundamentals of trading by consulting our guide dedicated to novice traders.
- It is essential to avoid mistakes with leverage; To learn how to avoid other mistakes you may encounter, check out our guide to the best trading lessons.
- We strongly recommend that you use the stop loss if you use leverage. Stop losses eliminate the risk of negative slippage when markets are extremely volatile.
- Make sure you know your broker’s margin policy to avoid margin calls.