Margin trading when forex trading is a way to access borrowed capital provided you deposit enough funds to meet the lender’s margin requirements. Use of margin unlocks access to leverage so you can take larger positions with less of your own funds.
Margin trading allows you to speculate on financial markets such as cryptocurrency, metals such as gold and silver, and forex markets with just a small deposit. Margin trading is a tool used by traders to access leverage, which allows you to access more capital for investment or trading purposes than you may have at hand.
This article looks at what margin trading is and looks at some of the key concepts one should be familiar with.
In forex and CFD trading, brokers allow you to trade on leverage, provided you have the minimum amount of unused account balance the forex broker requires in your trading account to open your position. This is known as margin trading. When trading with margin, your ability to open trades is not based on how much capital you have in your account, but on how much margin you have. Your broker needs to be assured you have enough cash to ‘set aside’ or use as a deposit before they will give you leverage.
Margin trading is the practice of using collateral to access leverage for investment purposes
When trading on margin, you can get greater market exposure, by committing just a small amount of money towards the full value of your trade upfront.
In Forex trading, margin is the amount you need to deposit or have deposited in your account, to access leverage or maintain a leveraged position. This deposit is a portion of the value of the trade or investment that you must ‘set aside’ or ‘lock up’ in your trading account before you can open each position you trade, forex margin is not a fee or cost.
Margin is the amount of unused funds you need in your trading account to open and maintain your position
This deposit is a good faith deposit or form of security to ensure both the buyer and seller will meet obligations, it is not a down payment as you are not dealing with borrowed money in the traditional sense. When trading with forex and CFDs, nothing is actually bought or sold as you are dealing with agreements or CFDs, not physical financial instruments.
The margin can be expressed in two ways. These are:
Margin can be expressed as a percentage of the ‘notional value’ or ‘position size’ of your opening position. This percentage is your margin requirement and is why you see margins matched to the derivative you are trading for example when trading forex, you may see:
To calculate the margin requirement the following formula is applied
Margin Requirement = 1 / Leverage Ratio
When Margin is expressed in currency, then it is the amount you will need in the currency of your trading account. The required margin is also sometimes called the initial margin, deposit margin or entry margin. This can be calculated as follows:
When your trading account is the same as the base currency, then your trading account will require the following trading margin:
Required Margin In Trading Account = National Value x Margin Required
When your trading account uses a different currency to the base currency, then the requirement for margin will be:
Required Margin In Trading Account = Notional Value x Margin Required x Exchange Rate Between Base Currency and Account Currency
When you close your position and complete the trade, your margin is returned to your account. This is known as ‘freed’ or ‘released and can be re-used to open new positions.
One other concept that should be understood when trading is ‘used margin’. If you open multiple trading positions at a time, each position or trade will have its own required margin. Used margin is the total of all required margins for all your positions that are open at one time.
While required margins only require you have enough funds in your trading account for a particular trade, used margin requires you have enough deposited in your account to keep all your trades open. This is sometimes called your maintenance margin.
Used Margin = Total amount of margin currently in use to maintain all existing open positions
Free Margin or usable margin is the difference between account equity and used margin.
Free Margin = Account Equity - Used Margin
There are two aspects to free margin, these are
The margin level is closely related to free margin. Margin level allows you to determine how much you have available to take a new position in your trading account. Margin level is calculated as:
Margin Level = (Equity / Used Margin) x 100%
A good trading platform will calculate and display your margin level. A higher margin level meant more free margin available for trading. A lower margin level means your trading account is at risk of debt and can result in a margin call or even stop out.
To ensure your account has a safe maintenance level and avoid a situation where your account may fall below the required margin, your broker will set a margin limit. This limit will usually be 100% but will vary from broker to broker. A 100% margin level means the account equity is the same as the margin.
In the event your margin level does fall below the broker’s margin limit, then a margin call will be triggered. When a margin call occurs, the broker will ask you to top out your account or close some open positions and will not allow you to open any new positions. If your account margin level continues to fall, then a stop out will be activated and the broker will attempt to close some or all open position to bring your trading account back above the margin limit.
In order to open your position, the broker will list either
The two concepts are often used interchangeably as they are based on the same concept however they are also different. The margin the broker requires will reflect the leverage you can access, on the flip side, the leverage the broker will allow shows the margin for the deposit the broker will require.
Leverage is the debt you take on to trade positions that are larger than the funds you have in your trading account. Leverage is a ratio between how much you have available to invest and the amount the broker will amplify your investment. This ratio is 1:Leverage. A ratio of 1:500 means that for every $1 you have unused in your trading account, the broker will give you an extra $500.
Leverage = 1 / Margin Requirement
For example, if margin requirement is 3% then 33 = 1 / .03
As previously discussed, the Margin requirement is how much unused capital you need in your trading account to access leverage. This is expressed as a margin percentage.
If the ratio is 400:1 then 0.25 = 1 / 400
Margin and Leverage have a directly inverse relationship. The below table shows the relationship between leverage and margin.
Brokers can set their own margin requirements as long as they confine to the conditions of the appropriate financial regulator. All European regulators such as the Financial Conduct Authority (FCA) and Cyprus Securities Exchange Commission (CySEC), as well as the Australian Securities and Investments Commission (ASIC), limit margin the maximum margin to 3% for major currency pairs and 5% for minor currency pairs when using a retail investor account. Traders that qualify for a professional account will require less margin as regulators consider these forex traders to have the expertise to trade with margin and have the funds to cope with any losing positions.
While margin trading is a good tool for forex trading to increase profits, it is important to realise that there are risks involved with margin trading. Margin trading means using leverage, and leverage means you are taking on debt. Should movements for currency pairs such as EUR/USD, GBP/USD and USD/JPY move in an unfavourable direction then your losses can significant leading to significant debt with your broker.
Forex is a complex financial instrument to master, so if you wish to trade on margin, it is important that trading is done responsibly. The best way this can be done is by only using the leverage you need for trading and avoid using leverage to hold larger positions when market volatility is high. It can help to use risk management tools such as stop-loss, guaranteed stop-loss and negative balance protection to help reduce the chances of incurring losses.
Justin Grossbard has been investing for the past 20 years and writing for the past 10. He co-founded Compare Forex Brokers in 2014 after working with the foreign exchange trading industry for several years. He also founded a number of FinTech and digital startups including Innovate Online and SMS Comparison. Justin holds a Masters Degree and an Honours in Commerce from Monash University. He and his wife Paula live in Melbourne, Australia with his son and Siberian cat. In his spare time, he watches Australian Rules Football and invests on global markets.