How Do You Trade With Margin In Forex?
Trading with margin is a huge concept to understand when trading financial markets especially when first introduced to Forex and Crypto. Its concept is very simply to trade using borrowed money to amplify position size when buying or selling these financial products.
A simple analogy is when someone is buying a house. When one purchases a property, you can put down a percentage of the purchase price (such as 20%). For example even though a property asset may be worth $500,000, a 20% deposit would be $100,000, which in this case the borrowed money would be $400,000 or the remaining 80%. If the property goes up 10% in value (an increase of $50,000) then the value of the asset would likewise increase to $550,000 and the investor would generate $50,000 profit if sold. Based on the original down payment of $100,000 the investor has made a return of 50% with the $50,000 profit. This principle applies exactly the same in Forex and Crypto.
The borrowed margin varies for different financial markets that one can trade. For example, some Forex brokers give lending 400-500 times the amount that is deposited into the account. So for every 1 unit, the trader can hold exposure of 400-500 times this amount – which is quite eye watering! Think of the risk that this creates, as this can amplify profits as well as losses. It is critical that margin is managed correctly.
In the stock market, the lending is a lot lower. Some brokers may only offer twice the value of the cash invested. So if for example you have $50,000 in the account, the broker may allow you to use up to $100,000 of buying power.
How is margin used in Forex?
Luckily your Forex broker will automatically calculate how much margin and how much cash you have left when you buy and selling currencies. This saves you the time on all the boring maths calculations! Despite not needing to be a maths expert when trading, there are a few concepts that you will need to be familiar with!
Equity – The equity is the amount of cash you have available to trade. If one deposits $5000 in an account then this is the amount of equity that is available.
Margin – This is the amount needed to buy or sell positions. If the broker allows you to put 1% margin down or 100:1 leverage (see our article on leverage), then for every 100,000 USD position opened, a trader will need $1000 in their account to be set aside as a deposit for each 100,000 USD position.
Used Margin – This is the amount that has been set aside from a traders account. Using the example above, if one opens with $5000 equity and opens a 100,000 USD position, then the used margin would be $1000.
Usable Margin – This is the amount left over for profits and losses. Again, using the example above, the usable margin is $4000. This $4000 is used to absorb any losses and will increase if the position goes into profit. Again, as way of example, if the value of one pip (see our article on pips and values) is $10 per pip, then for the usable margin of $4000 to be absorbed, the market would need to go against the trader 400 pips ($4000 / $10 per pip = 400 pips). Once the usable margin hits zero then it is likely the trade will be liquidated or closed as there is no more equity in the account to absorb the loss.
Margin call – As used in the example above, when usable margin hits zero then a margin call is automatically issued and the trade is liquidated or closed. The margin call function is enabled to protect traders from the trade going too much against them and to protect losing more than what is in the account.
Stop out levels – It is definitely worth talking to your broker to find out what its stop out levels are for its clients. The minimum for European brokers (see our article on ESMA regulations) is 50% stop out of the margin. So in the example above if the level is 50% then the trade would be stopped when the account has $500 left. This is because the trades are liquidated based on 50% of margin is hit. The example above had one trade open which required $1000 margin. Once 50% of that is gone then the trade is closed with $500 left in the account. This means the trade lost $4500 and is closed to protect a trader from losing more!
Ways to prevent a margin call
To prevent a margin call there are two main ways that a trader can use.
- Deposit more funds to boost the equity in the account
- Close some of the existing positions to reduce the ‘Used Margin’ levels
A good broker should let one know when a margin call is close by sending alerts through text or email. This will then give a trader enough time to react and decide on one of the main methods above.
- While trading with margin is perceived as a risky endeavor, there are also plenty of advantages if it is used in the right way. A trader can amplify their gains without holding too much cash with the broker if used correctly.
- Despite the above, margin can be used successfully and only the best traders know how to use margin in a smart way. It is extremely important for a trader to fully understand the concepts above for managing margin in the correct way.