You have probably heard the terms “margin” or “margin requirements” if you are a forex trader. Often labelled as a good faith deposit, it is usually expressed in terms of percentage such as 0.5%, 1%, 2% and so on. Based on the margin required by the broker you have chosen, you have to calculate the maximum leverage you can use with your trading account.
Now before we move ahead with explaining how margin impacts forex trading, there are a few related terms that we need to take a look at.
- Profit margin: The amount of revenue from sales exceeding costs in a business (doesn’t really apply to forex trading). It can be expressed as gross profit margin as well.
- Margin account: The account you have to open in order to start trading using margin funding.
- Leverage: The term used for borrowed money to invest in a currency.
- Lot: The unit in which forex is commonly traded. It consists of a standard lot, mini lot, micro lot and nano lot.
- Maintenance Margin: It ensures that the trader has enough capital to keep their positions open. It should also cover any existing losses.
How to calculate margin in FX trading?
When trading currencies, you may be trading a currency pair that is entirely different from the currency used in your account. The margin requirement for this kind of trades have to be calculated to proceed and the difference in currencies makes this job difficult. Looking at the following example will help make things clearer.
Suppose that you have decided to trade the Great Britain Pound(GBP) and the Japanese Yen(JPY) and the base currency in your account is the United States Dollar(USD). You decide to take a 10000 unit position which means buying 10000 GBP against the same number of JPY. This means you have to pay in JPY to buy GBP but in reality, you're using USD to buy the JPY. The margin calculator will calculate your margin requirement based solely on the USD or your main account currency.
The formula required for calculating margin requirement is as follows:
[(Base currency/ Account currency)*Units]/Leverage
Let's say that GBP/USD is at 1.30.
Thus margin for this trade is 1.38*10,000/30= $433.33USD.
Now if we apply this while trading EUR/USD, the current conversion price for this pair is 1.2117. If you want to purchase 500,000 units or 5 standard lots at a 30:1 margin, you would need $20.295.5 to open this position.
Relationship between margin and leverage
Leverage, which is also known as margin ratio, can differ depending on the broker you have chosen. A typical margin requirement provided by brokers is 30x. Now if there is a margin of 20x, the increased ratio of leverage reduces profit potential and purchasing power. On the other hand, if the leverage is increased to 50x, the new margin requirement gets reduced to $260. However, this also increases your potential losses by 67%.
You may be attracted to lower margin requirements as it allows you to take the same position by investing a lot less. But this goes both ways, as the risk will also be amplified with a lower margin. If you fail to consider these implications, you could end up incurring losses before you even realize them. High leverage on the other hand will ensure that your margin call won't come quickly.
What is a Margin Call? (instances and examples)
You may hear many traders saying: “Never meet a margin call as you’re on the wrong side of the market”. A margin call refers to the situation where a trader no longer has any usable margin to trade and his/her account needs funding. This usually happens if your account loses the usable margin accepted by your broker, due to incurring large losses.
Such a situation usually occurs when a trader commits a substantial amount of his/her capital to used margin. This leaves less room to incur losses for the trader. Brokers have the margin call system in place as it helps to reduce their risk substantially. Some of the reasons why margin calls can occur include: trading without stops when the price moves in the opposite direction, underfunded account, over-leveraging your account and holding on to a losing trade for too long.
How does a margin call work?
When triggered, the margin call liquidates or closes the trades of the trader. This is done for two reasons: The trader no longer has money to sustain his/her positions and the broker incurs losses on his/he behalf. In certain cases where more leverage has been used, a trader may be liable to pay the broker more than what he/she has deposited.
To understand this clearly, let's take the help of an example.
Suppose you have deposited $10,000 and have traded 4 standard lots. Your margin percentage is 2 per cent. For a EUR/USD pair trading at 1.125, the used margin is calculated as follows.
[Trade size x Margin percentage x Price x Number of Lots = $9000 in this case. Thus free margin, in this case, is $1000. Now assume that this is the sole position open. To maintain this position, the majority of the account equity is used up, leaving only the $1000 free margin. You may be tricked into thinking that your account is in good condition at this point. However, more leverage means your account is less capable of handling large movement against the trader. So in this case, if the market moves more than 25 pts, the trader will trigger the margin call and have his/her position liquidated. It is calculated as follows: ( $40 per point * 25 pts) = $1000.
Tips to Avoid Margin Call
Leverages has always been a danger as well as a gift. The bigger or greater leverage a trader uses, the less available margin(usable) the trader will have to incur losses. The danger arises when traders get swallowed by an over-leveraged trade that depletes their account. You will get a margin call when the usable margin hits nil. You should thus use protective stops to limit losses to a minimum. The following are some important tips to avoid receiving a margin call for a forex trader.
- Always keep a substantial amount of free margin with you. Many brokers recommend using no more than one percent of the account equity on a single trade.
- Change your trading approach to trade smaller sizes.
- Use stops to limit your losses as part of prudent risk management.
- Always look to reduce your effective leverage.
Pros and Cons of Margin Trading
If done correctly, there's absolutely nothing to worry about when using margin in FX trading. To better explain this let's take a look at the pros of margin trading.
Pros of Margin Trading
- The most obvious advantage of using margin is to control a larger amount of money by borrowing it from the broker.
- Trading with margin also gives the trader the flexibility to work on a portfolio. With margin, traders can use their equity to open more than one trade at the same time. This allows you to diversify using various instruments on a daily basis.
- It was pretty difficult for traders to grow their accounts rapidly before the advent of margin trading. Small traders found it almost impossible to manage big positions and day trading instruments. With margin trading, you get the opportunity to take on various markets simultaneously, during the day which helps to exponentially grow your account.
But like everything, there are negative sides to margin trading as well. Taking note of these and avoiding them will help traders use them more effectively.
Cons of Margin Trading
- The ability to control a larger position than you normally would do also amplifies your losses. This makes it important for traders to apply risk exposure and money management rules when trading on margin.
- The danger of margin calls is always present. It can either wipe out a substantial part of your account or your entire account depending on whether you’re using stop losses or not.
- Some traders cannot handle the emotional aspect of trading, particularly the stress of having a big position. Too many times, fluctuations in prices can lead to irrational decisions. While trading with margin, it is thus important to always keep your emotions in check. In case they a trader cannot handle such large profit and loss fluctuations, they should consider decreasing their position sizes.
Margin trading can be advantageous to traders only when they have understood how to apply it. You should engage in forex margin trading when you are aware of all the risks and costs involved, have extensive experience of trading volatile markets and understand that your position can be automatically closed even if you do not close it yourself.
Apart from this FX margin trading is also not suited for all trading styles. You have to constantly monitor the trade during a small period. Even holding your position overnight can expose you to greater risk and additional costs so you should consider investing enough capital before trading.