What Is Margin Trading?
The forex (or foreign exchange) is a financial market where major currencies are bought and sold. Forex trading is always done in pairs; essentially you are always selling one currency to buy another.
To trade forex, the investor will open an account with a broker. The investor can choose to trade on a cash or margin basis. In margin trading, the broker gives you leverage and you have to put down a deposit, or margin.
This article will explore the reasons to consider margin trading, how to calculate margin and will give you an understanding of the risks involved.
In forex, investors use margin trading to increase possible return on investment.
Using a ‘margin account’, an investor will use their own funds to put forward a percentage of a larger value investment, with the broker putting forward the rest.
Even taking into account fees and commission, the theory is that the larger the sum of money that can be traded, the bigger the profits for the investor.
The margin account is essentially similar to a short-term loan that allows the investor to have a bigger stake in the market and therefore, it is hoped, receive greater returns.
Margin trading should be seen as a way to borrow money by putting up a ‘good faith’ portion of account equity, rather than as a cost or a fee.
To commence margin trading, the investor opens an account with a broker using the required percentage of the full value of the proposed trade (the margin). The required percentage is calculated to cover any losses should they occur.
The margin is the proportion of the trader’s funds that are set aside (also referred to as ‘used’ or ‘locked up’) for the length of time the trade is open – this is essential to have an open trade.
Every broker will have different requirements, so investors will want to consider all their options before choosing a broker and starting to trade.
When the trade is completed, the margin returns to the trader’s account as ‘freed’, ‘released’ or ‘usable’, and can be used to enter into new positions.
The main benefit of an FX trader using margin is the ability to leverage investments and increase their returns. They can use margin trading to trade in far larger sums of currency than their principal investment would usually allow.
Unlike typical stock brokers, forex brokers don't, as a rule, charge interest on the money they put in.
The margin size is much greater than that found in the stock market generally, with the minimum ratio being 10:1 rather than 2:1, which means FX traders can leverage greater sums.
So for example, an FX trader who starts with £100 as their principal investment, with a 50:1 leverage, can invest £5,000 worth of currency. That presents FX traders with a huge advantage when it comes to realising gains in the market.
Other benefits include:
- Flexibility and speed in trading. The market can move fast and some opportunities may pass before the trader can release funds. Margin trading allows the trader to have more liquidity to take advantage of more opportunities.
- An easier way to raise finance. Margin trading can be a useful way to access additional funds.
Margin requirements vary depending on the broker and size of the trade. Typical forex margin requirements can be 2%, 1%, 0.5% or 0.25%. For accounts that will trade in over 100,000 currency units, the margin percentage is usually around 1% or 2%.
Each trade or position that a trader wishes to open will have its own ‘required margin’ amount that is required to be ‘locked up’ or kept to one side.
If the base currency is the same as the account’s currency, the calculation for required margin is:
Required Margin = Notional Value x Margin Requirement
If the base currency is not the same as the account’s currency, the calculation for required margin is:
Required Margin = Notional Value x Margin Requirement x Exchange Rate Between Base Currency and Account Currency
For example, a trader pays £1,000 into their margin account and decides to go long USD/GBP at 1.50000 and wishes to open a position of one mini lot (10,000 units). The mini lot is worth £10,000 and the position’s notional value is £15,000. If the margin requirement is 5%, the required margin will be £750.
But, if a trader wished to go long on USD/EUR and open one mini lot (10,000 units) and the trading account is a GBP account, the first step is to calculate the USD/GBP price. If USD/GDP is trading at 1.1000 the notional value is 11,000. If the margin requirement is 3%, the required margin will be £330.
What Is Used Margin?
Each position will have its own specific required margin. The broker will add together all of the required margins for open positions and that total sum is the used margin.
What Is Equity?
Equity is another word for the value of your account in real time. If you have no open trades then ‘equity’ equals the balance. If you have open trades, ‘equity’ is the account balance plus the floating profit (or loss) of all your open positions.
What Is Free Margin?
The free margin is the difference between equity and used margin and can be either:
> The amount a trader has available to open new positions
> The amount that existing positions are able to move against the trader (i.e. downwards) before the trader receives a margin call or stop out.
What Is Margin Level and Margin Call?
The margin level is a percentage value calculated by the ratio of margin to available equity. It is used by the broker to determine whether an FX trader can take a new position.
It is calculated by assessing the accessible usable margin against used margin:
Margin Level = (Equity/Used Margin) x 100
The limit applied varies from broker to broker but it is most common to set the limit at 100%. A 100% margin level is when account equity is equal to margin.
If a trader’s account reaches the margin level (for example, the FX trader will no longer be able to cover any continued or potential losses), the broker will make a margin call and the trader will not be able to take any new positions.
If the trader continues to have losing positions, the stop-out level will be reached. The stop-out level is the defined point that a broker will close a trader’s active positions. The broker can no longer support the open positions due to the decrease in margin levels.
It is possible to avoid margin calls being made by careful monitoring of the account balance and minimising risk when considering positions.
There are several risks to margin trading on forex:
1. Systemic Risk
The main risk of margin trading on forex is systemic risk; for example, the risk that the whole market may be affected by something outside of its control and, at the most extreme, may cause the entire financial system to collapse.
Systemic risks can include:
- Financial decisions such as inflation, growth, interest rates, etc.
- Conflict, war, terrorist attacks, natural disasters
- Strikes, political conflicts and elections
- Regulatory and legislative changes
2. Leverage Risk
The higher the leverage the greater the money made, but also the greater the risk of loss. A broker may offer high leverage (some may go as high as 400:1) but traders do not have to use that level of leverage.
3. Liquidity Risk
In general, forex is a reasonably liquid financial market but even forex is susceptible to periods of low liquidity. Bank holidays and weekends can even cause a dip in liquidity – and during these periods, the cost of trading will increase.
Forex margin trading brings both benefits and risk to traders. With careful management, a trader can take advantage of high leverage offered by brokers to make rewarding trades, but like any kind of financial investment, traders should ensure that they are knowledgeable of the entire system, including associated risks, before committing to spending large sums of money on margin trading.
Forex is a reasonably liquid market and accessible to traders with relatively modest amounts of capital. However, margin trading on forex with modest sums is unlikely to reward traders with enormous fortunes. As with any investment, the higher the capital spend, the bigger the rewards; but this also brings the greatest risks.
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