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What is margin in forex trading?

What Is Margin in Forex Trading and How Does it Affect Me?
Margin is one of the most important concepts in forex trading. Every forex broker offers margin trading and it is imperative that every prospective or active trader understands how it works.

Forex trading is the process of converting the currency of one country into another, aiming to make profits from the difference in the exchange rates. The foreign exchange market is the global virtual marketplace where traders buy and sell currencies every week day, that is, 24/5. Only the large international banks and big investment firms have direct access to trade in the forex market because they buy and sell huge volumes.
Individual forex traders can only access the forex markets via online forex brokers who are basically financial service providers that provide software platforms on which clients can open and close forex trade positions.

Content:
  1. What is a Margin in Forex Trading?
  2. Terms associated with Margin
  3. Advantages of forex margin
  4. Risks Associated with Margin Trading
  5. Summary
  6. FAQ: How Does Margin Work in Trading?

What is a Margin in Forex Trading?

Margin is the amount of money that a trader needs to put forward as a good faith deposit in order to open positions greater than his invested funds. It is usually expressed as a percentage of the full value of the forex positions opened.

For example if a trader wishes to open a position of 1 lot on the US dollar vs. South African Rand pair (USDZAR) at 14.8170, his broker offers a margin of 5%, what is the margin required?

Total amount required to open the position = contract size X price

                         = 100,000 X 14.8170 = 1,481,700 ZAR

Required Margin (5% of total value) = (5/100) X 1,481,700 = 74,085 ZAR

So, with only 74,085 ZAR; the trader can open a trading position worth 1,481,700 ZAR. The broker locks this amount in the trader’s account using it as a form of collateral in case the trade goes against the trader’s position.

Traders can easily calculate forex margin using a ‘forex margin calculator’ which are usually provided by brokers on their clients’ areas or websites. This is a software tool that calculates the initial margin requirement when you input the currency pair, trade size, your account currency and leverage.

Every broker lists its forex margin requirements usually as part of its contract specifications. The margin percentages vary from one broker to another, some offer more margin than others. Popular margins offered are: 1%, 5%, 0.01%, etc. In some cases, regional restrictions are imposed on margin; for example, the European Securities and Markets Authority (ESMA) limits the margin offered by European brokers, so, brokers regulated by Cyprus Securities and Exchange Commission (CySEC) or Financial Conduct Authority (FCA) are restricted to a maximum forex margin of 3.3% for retail traders. Also, the CFTC limits how much margin is available to US traders; currently it is capped at 2%. 

Terms associated with Margin

Leverage

Margin in forex trading is also referred to as leveraged trading. Both terms are equally important though they are similar. Leveraged forex trading means that the trader is allowed to open trading positions that are larger than his invested capital. It is written as a ratio of the trader’s funds to the broker’s funds while margin is expressed as a percentage. Every broker states its maximum leverage for every asset class or trading instrument available.
Let us illustrate with an example:

A margin of 2% means that a trader is required to deposit only 2% of the total amount required to open the trade position, while the broker provides the remaining 98%. In terms of leverage, it means 1:50; for every amount of money put forward by the trader, the broker provides 50 times of it.

In the same vein, 1% margin = leverage of 1:100; 20% margin = leverage of 1:5 

Equity

The account equity is the total account balance in a trading account when there are no open positions. But when there are open positions, there will be unrealized profits or losses, so, the total account equity becomes the aggregate of the floating profits or losses and the deposited funds. When forex trades are in progress, the trading platform automatically updates the trading account balance in real time; if the trader is on a winning trade, it is regarded as floating profits and losing trades are recorded as floating losses until the trade is closed.

Margin requirement

This is the exact amount of down payment needed before the broker can allow you to open the full trade position. Let us illustrate with an example:

Assuming a trader has account equity of $1,000 and he wishes to short selling positions on 2 mini lots of the EURUSD at 1.16477 on a margin of 1%, what is the margin requirement?

Notional value of trade: contract size X price = (2 X 10,000) X 1.16477 = 23,295.40 USD

Margin required = (1/100) X 23,295.40 = 232.96 USD 

Used and free margin

Used margin is the total margin requirements for all open positions in the trading account. It is locked up by the broker during the trade because it serves as a form of collateral in case the trade goes against the trader’s position. Free margin is the part of the trader’s account balance that is not locked by the broker as margin; it is free and can be used to open more positions. Free margin is also known as the usable margin and it is equal to the account balance when there are no open positions. Let us elucidate with an example:

Steve is a professional forex trader who analyzed the forex market by using strategies derived from technical analysis. He has a total of $4,500 in his trading account and decides to go long on the EURUSD and GBPUSD but open a short position on the AUDUSD. If his contract size is 1 lot for each pair and margin is 1%, calculate the used and free margin. (Entry prices EURUSD = 1.16166, GBPUSD = 1.38136 and AUDUSD = 0.75084

First calculate forex margin for each forex pair:

                              (margin percent) X (contract size) X (price)

Margin requirements for:
EURUSD = (1/100) X (100,000) X 1.16166 = 1,161.66
GBPUSD = (1/100) X (100,000) X 1.38136 = 1,381.36
AUDUSD = (1/100) X (100,000) X 0.75084 = 750.84 

Total margin requirements = 1,161.66 + 1,381.36 + 750.84 = 3,293.86

Therefore, used margin = $3,293.86

Free margin = Equity – Used margin = $4,500 - $3,293.86 = $1,206.14

It means that approximately $1,206.14 is not locked by the broker and can be used to further trade forex. Please note that the example above is for illustration only, the broker’s spread charges or transaction cost have not been factored into the calculations. Also, the currency rates actually fluctuate in real life; the quotes above do not represent the exchange rates. 

Margin level

The forex margin level is very important because it gives a measure of the trader’s funds available for opening new positions. In fact, every broker states its margin level and the limits. It is automatically calculated and displayed in real time on most trading platforms.

Margin level = (Equity/used margin) X 100

Forex margin level is defined as the ratio of the trader’s equity to the used margin expressed as a percentage. So, an account that has no open trades has a margin level of zero. If the margin level is 100%, it means that the whole account equity is in use by the open positions; this is the minimum margin level allowed by most brokers.

From the example of Steve’s trade above:

Account balance = $4,500; with three open positions with total margin requirements of $3,293.86

Therefore, Margin level = (4,500/3,293.86) X 100 = 136.62% 

Margin call

This is a call to action issued by a broker to a trader when the margin level reaches a specific threshold known as the margin call level. It means that the floating losses are increasing and it is probably more than the used margin. Most brokers set the margin call level at 100%. Depending on the broker, margin calls come in form of sms, phone call, email, platform or app notifications.  In its contract specifications or website, every broker states its margin call level.

Generally, margin calls shake up traders emotionally, so, traders try as much as possible to avoid it. But, traders respond to the call by depositing more money into the account or closing the losing positions. 

Stop out level

The stop out level is a threshold set by brokers at which the broker starts closing out loosing trades. This happens because of insufficient margin to sustain the open positions.

Assuming the trader (Steve) maintains his 3 open trade positions but unfortunately a trade goes against his forecast and he starts loosing. At a point, another trade reverses against him too; his margin level falls to the margin call level and he is notified via a margin call. Steve does nothing because he believes that his analysis was correct and the trades will soon reverse again in his favour. But, he was wrong and he kept losing. At a point his margin level drops to 20% which is his broker’s stop out level. At this point, the broker starts an automatic liquidation process by closing out his positions starting with the most losing one until the margin level goes up again. 

Advantages of forex margin

Higher potential profits

In forex trading, the small price movements are measured in pips. It is given as 0.0001 units or 0.01 units depending on the forex pair. For example, if the EURUSD moves from 1.16429 to 1.16489, then it has gained:  (1.16489 – 1.16429) = 6 pips.

For every pip movement, the trader makes a gain or suffers a loss that is dependent on his position size. With a high forex margin, you can increase the value of a pip and make huge profits from small price movements; though it is a high risk strategy. This is what scalpers do. 

Low trading capital

The capital required to become a forex trader has been drastically reduced by forex margin. This is why you can open a forex trading account with only a paltry sum such as $1, $10, $50, $100, $300, etc. The initial investment amount wholly depends on the broker. So, anyone can start trading forex with a little amount of money; this is why several people are plunging into forex trading without adequate knowledge or strategy but they are hoping to make profits. Hence, every broker reports that a large percentage of retail investor accounts lose money while trading CFDs and forex with them.

Risks Associated with Margin Trading

The major disadvantage of margin in forex trading is that you stand a high risk of losing a huge part or all your invested capital. Just as high margin increases your market exposure and profit potentials, it equally multiplies your loss potentials if the trade goes against your prediction. For example, if you have a margined account and opened a position where the value of 1 pip equals $40; if you gain 20 pips, you have gained $800 but if the trade reversed and you lost 20 pips, you have equally lost $800. So, forex margin can multiply losses as well as profits.

Summary

Margin is very important to forex brokers and traders alike. It is basically the deposit made in order to open large positions that are in multiples of the invested funds. Free margin is used to open more positions while used margin is locked by the broker to cover for the opened positions. Margin level is always calculated by the broker; when it falls to the margin call level, the trader is notified to take action but if no action is taken, it may reach the stop out level at which the open trades are liquidated. Most brokers provide its traders with a forex margin calculator.

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  • On its cutting edge platforms, up to 350 assets can be traded including forex, commodities, cryptocurrencies, indices and stocks CFDs.
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  • Margin trading is fully supported on all assets.
  • Client trades are executed in less than a second and traders are supported with essential tools for education, analysis and risk management. 

FAQ: How Does Margin Work in Trading?

What does 5% margin mean?

It means that you are required to deposit only 5% of the total worth of the trading positions you wish to open before you are allowed by your broker to open the positions. 5% margin is equal to a leverage of 1:20.

What triggers a margin call?

It is triggered by losing positions. The call level is set by your broker and it is triggered once your free margin is used up to the extent that the margin call level is reached.

How much margin should I use?

It all depends on your goals, strategies, trading style and capital. For example; if you use scalping strategy, then, high margin and good exit strategies may be good for you. But, always know the risks involved with using fx margin.

Do not forget that no matter your strategy, there are no guarantees because there is no way of absolutely predicting the markets. Previous good performances do not in any way guarantee future performance. Even if you trade without margin, significant risk is still involved once you are trading CFDs and forex.
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