In forex trading, the concept of margin is one of the most important concepts that must be fully understood. Margin is essentially the amount of money that a trader must provide to enter a trade and keep it open. Margin is not a transaction cost, but rather a collateral that the broker holds as long as the forex trade is open.
Traders should be aware that if their margin level falls below the minimum required level, their trades will be automatically closed by the broker. In the following, we will step by step examine the concept of margin and its related details.
What is the margin?
Margin is the amount of money required to open and maintain a trade. Margin acts as collateral and is typically expressed as a percentage of the total trade value.
There are generally two types of margin:
Used margin: Used margin is the amount of capital that is currently being used as collateral to maintain open positions.
Free margin: This is the remaining amount of capital available to open new positions. For example, if your total account balance is $5,000 and your used margin is $3,800, you will have $1,200 of free margin to open new positions.
To calculate margin, the following formula can be used:
Margin = (Volume × Contract size × Asset price) / Leverage
For example, let’s say you want to trade 3 lots of EUR/USD with an asset price of $1.10 and a leverage of 30. You will need a margin of $11,000 to open the position.
(3 x 100,000 x 1.10) / 30 = $11,000
The role of margin in leveraged trading
When considering this, it’s important to remember that the two elements of margin and leverage are complementary and work together. Leverage allows you to trade a larger financial position with a smaller amount of money. On the other hand, margin is the initial capital required to open a leveraged trade. The combination of margin and leverage allows you to generate higher returns on your initial investment using the funds in your account. However, if the market moves against you, you may experience significant losses.
In essence, margin is the amount of money required to open a position, while leverage means you can enter positions larger than your account balance.
The function of leveraged and margin trading
When asking how margin works, the most important thing to remember is that margin and leverage trading allows you to make trades that would not be accessible without these tools. Once you understand how leveraged trading works, this tool can be a powerful lever to increase your profits. By using only a fraction of the trade value, you can have the same return as a regular trade. On the other hand, leveraged trading can lead to significant losses and rapid depletion of your capital.
What is the margin level?
Simply put, margin level indicates the health of your trading account. This ratio represents your equity divided by the used margin for your open positions, expressed as a percentage. The formula is as follows: Margin Level = (Equity / Used Margin) x 100
For example, let’s say a trader has an account equity of $5,000 and a used margin of $1,000. In this case, their margin level would be calculated as follows: Margin Level = (5000 / 1000) x 100 = 500%.
This margin level is considered to be a very healthy account. A good way to know if your account is healthy is to ensure that your margin level is always above 100%.
How does a trading account’s margin level increase or decrease?
If your open trades incur losses, your account equity will decrease, and consequently, your margin level will also decrease. Conversely, if you make profits, your equity will increase, and your margin level will rise.
What should you do if your margin level falls below 100%?
If this happens, it’s time to deposit more funds into your account or close some of your positions to keep all your open trades active. Otherwise, the broker will start closing your positions, beginning with the largest one.
What is the margin call?
What happens if the margin level continues to decrease?
If your margin level drops significantly, you will receive a margin call. This alert informs you that your margin level has fallen below a predetermined threshold. This threshold can vary between different brokers. After receiving a margin call and reaching the specified limit, the broker will automatically start closing your positions to prevent your account balance from going negative. This process continues until your account balance reaches zero, and the trader is said to have been ‘stopped out’.
It’s worth noting that the choice of broker plays a significant role in this matter, and selecting the right one can have a substantial impact on margin management. For instance, a key advantage of Mond FX for Iranian traders is its 24-hour support, which allows traders to address any margin-related issues promptly.
Example:
Your account balance is $5,000, and your margin call level is set at 40%. Your trades are not performing well, and you’ve incurred a loss of $3,800.
You have used $1,000 of margin, so your current margin level is calculated as follows:
Margin Level = ( 5000−3800 / 1000 )×100 = 120%
If your margin level decreases by another 80%, you will receive a margin call. At this point, it’s time for you to either deposit more funds or close your losing positions to free up more margin.
Preventing Margin Calls
When entering a trade, it’s crucial to closely monitor your margin level and take proactive measures to prevent margin calls. A margin call occurs when the value of your account falls below the required margin level. In other words, your trading account balance is insufficient to cover your open positions. If your account drops below the minimum margin requirement, your broker may issue a margin call, demanding that you deposit additional funds or close some of your positions. Margin calls can be stressful and costly, but they can be avoided by using proper risk management strategies.
To help you avoid margin calls, here are some tips to consider:
- Using Stop-Loss Orders: Stop-loss orders are a crucial tool for risk management when margin trading. A stop-loss order is an order that closes a trade when the price reaches a specified level. By using stop-loss orders, you can limit your potential losses and protect your account from margin calls.
- Monitoring Your Positions: Regularly monitoring your open positions and account balance is crucial. By monitoring your positions, you can identify potential margin call situations earlier and take the necessary steps to prevent them.
- Maintaining Sufficient Account Balance: Maintaining a healthy account balance is one of the best ways to avoid margin calls. A higher account balance means you have more margin to cover your open positions. Additionally, having sufficient account balance can help you tolerate market fluctuations and prevent liquidation.
- Avoiding Excessive Leverage: Overusing leverage can quickly lead to margin calls. It’s essential to use leverage wisely and avoid taking on excessive risk. A general rule of thumb is to not risk more than 2% of your account balance on any single trade.
Preventing margin calls requires careful planning, risk management, and discipline. By utilizing stop-loss orders, monitoring your positions, maintaining sufficient account balance, and avoiding excessive leverage, you can minimize the risk of margin calls and protect your account from significant losses.
Final Words
In forex trading, where leverage is utilized, margin is a critically important concept that must be thoroughly understood. Margin is essentially the amount of money that a trader must deposit to open and maintain a position. Margin is not a trading fee but rather a security deposit held by the broker while a forex trade is open.
Traders should dedicate sufficient time to understanding how margin works before leveraging the forex market. Grasping concepts such as margin level and margin call is of paramount importance.
Traders should be aware that if their margin level falls below the minimum required level, their broker may automatically close their positions. To start and learn professionally in the financial markets, the comprehensive “Zero to Hero Forex Training” course by Mohammad Ahangari Asl could be the best available option.
This course, covering topics from beginner to advanced levels, prepares you for the challenges of the financial market. By learning professional trading strategies and risk management techniques, you can increase your chances of success in the competitive world of trading. To learn more and enroll in this training course, take action now and take a big step towards becoming a professional in forex.
Frequently Asked Questions
- What is Margin?
Margin is the amount of money a trader needs to open and maintain a trading position. This money is held as a security deposit by the broker and is not a trading fee.
- What is Margin Level?
Margin level is the ratio between the account equity and the used margin, expressed as a percentage. If the margin level falls below 100%, what happens?
If your margin level drops below 100%, you may need to deposit additional funds into your account or close some positions to bring your account back into a margin-covered state.
- What is a Margin Call?
A margin call occurs when the margin level drops to a point where you need to deposit additional funds into your account or close some positions. This notification is typically issued when the margin level decreases to a specific percentage (e.g., 40%).