Margin is the minimum amount of money required to place a leveraged trade. Closely linked to margin is the concept of margin call – which traders go to great lengths to avoid. Not knowing what margin is can turn out to be extremely costly which is why it is essential for forex traders to have a solid grasp of margin before placing a trade.
Keep reading to learn more about margin in forex trading, how to calculate it, and how to effectively manage your risk.
What is margin in forex?
Margin is a good faith deposit that a trader puts up as collateral to initiate a trade. Essentially, it is the minimum amount that a trader needs in the trading account to open a new position. This is usually communicated as a percentage of the notional value (trade size) of the trade. The difference between the deposit and the full value of the trade is “borrowed” from the broker.
FX margin example
Below is a visual representation of the margin requirement relative to the full trade size:
Trade size: $10 000
Margin requirement: 3.33%
Understanding the connection between margin and leverage
Before continuing, it is important to understand the concept of leverage. Leverage and margin are closely related because the more margin that is required, the less leverage traders will be able to use. This is because the trader will have to fund more of the trade with his own money and therefore, is able to borrow less from the broker.
Leverage has the potential to produce large profits AND large losses which is why it is crucial that traders use leverage responsibly. Take note that leverage can vary between brokers and will differ across different jurisdictions – in line with regulatory requirements. Typical margin requirements and the corresponding leverage are produced below:
Understanding forex margin requirements
Margin requirements are set out by brokers and are based on the level of risk they are willing to assume (default risk), whilst adhering to regulatory restrictions.
Below is an example of the margin requirement for GBP/USD under the heading, “Deposit Factor”:
More often than not, margin is seen as a fee a trader must pay. However, it is not a transaction cost, but rather a portion of the account equity that is set aside and allocated as a margin deposit.
When trading with margin, it is important to remember that the amount of margin needed to hold open a position will ultimately be determined by the trade size. As trade size increases, traders will move to the next tier where the margin requirement (in monetary terms) will increase as well.
Margin requirements can be temporarily increased during periods of high volatility or, in the lead up to economic data releases that are likely to contribute to greater than usual volatility.
The first two tiers maintain the same margin requirement at 3.33% but then escalate to 4% and 15% in the following two tiers.
After understanding margin requirement, traders need to ensure that the trading account is sufficiently funded to avoid margin call. One easy way for traders to keep track of their trading account status is through the forex margin level:
Forex margin level = (equity / margin used) x 100
Suppose a trader has deposited $10 000 in the account and currently has $8 000 used as margin. The forex margin level will equal 125 and is above the 100 level. If the forex margin level dips below 100 the broker generally prohibits the opening of new trades and may place you on margin call.
It is essential that traders understand the margin close out rule specified by the broker in order to avoid the liquidation of current positions. When an account is placed on margin call, the account will need to be funded immediately to avoid the liquidation of current open positions. Brokers do this in order to bring the account equity back up to an acceptable level.
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