Margin trading made simple
One of the features of forex and CFD trading that makes it appealing and interesting is margin trading. With a little deposit, a trader can open large trade positions thereby increasing his chances of possible higher returns. Margin is a specified amount of money required as collateral by the financial service provider before allowing a trader to open larger positions. It is normally represented as a percentage of the total amount required to fund the trade position.
Table of contents
- What is Margin trading?
- Margin and Leverage
- Margin trading terms
- Risks of margin trading
What is Margin trading?
Margin trading is the practice of buying and selling of a financial asset with funds borrowed from a Advisor or a financial service provider. A trader can open positions much larger than his account balance through margin trading. For example, a trader wishes to open a ‘buy’ position for 1 lot of EURUSD pair at an ask price of 1.18115. If his account currency is USD, a total cash balance of $118,115 is required to fund this position. But, on a 1% margin from the financial service provider, the trader only needs a deposit of $1,181.15 to open this trade position.
Margin and Leverage
Financial service providers state the maximum leverage allowed on their trading accounts as well as the margin percentage required on tradable assets. This is because leverage and margin are related as they are important trading tools used in forex and CFD trading. Leverage trading also enables traders to increase their trading power by opening positions much more than their account balance. Leverage is expressed as a ratio while margin is expressed in percentage. For example, a leverage of 1:50 is equal to a margin of 2%.
Leverage = 1/margin
And Margin = 1/ Leverage
For a margin of 2%, the leverage is 1/2% = 1/0.02 = 50
Therefore, the leverage is 1:50
Margin trading terms
There are some important terms that are associated with margin trading. It is very necessary for every forex and CFD trader to perfectly understand these terminologies before live trading. We will illustrate these terms with an example:
A CFD trader made a deposit of $1,500 into his account. He wants to go long on the GBPUSD for 1 mini lot at 1.30512. He also wants to simultaneously buy 1 mini lot of the USDJPY at an ask price of 106.983. His financial service provider has margin requirements of 5% for GBPUSD and 4% for USDJPY.
This is the total amount required to fund a trade. For the example above, to buy 1 mini lot (10,000) units of GBPUSD at 1.30512 without leverage will cost:
10,000 X 1.30512 = $13,051.20 = Notional value
For the USDJPY trade, if the account currency and the base currency is USD, therefore
Notional value = $10,000
This is also known as the ‘initial margin’ or ‘deposit margin’. It is the down payment required by the financial service provider to maintain the full trade position. Once the trade is in progress, the required margin in locked up for the duration of the trade and only released when the trade is closed.
For the example above,
Required margin = Notional value X margin %
So, for the GBPUSD trade, the required margin = $13,051.20 X 5% = $652.56
For the USDJPY trade, the required margin = $10,000 X 4% = $400
Used margin is the total sum of all the margins on all open positions. It is the total amount of money that is locked up during one or more trades. From the example above,
The Used margin = required margin of the GBPUSD trade + required margin for the USDJPY trade
Used Margin = $652.56 + $400 = $1,052.56
So, out of the trader’s deposit, $1,052.56 is locked up for the duration of both trades.
Free margin is the portion of the trader’s balance that is not tied to any margin in the currently open trade positions. This part of the trader’s equity is free and can be used to open more positions. It is also known as ‘Usable margin’. For a margin trading account without any open position, the free margin is equal to the account balance.
For the example above, let us calculate the free margin when the two trade positions are open.
Free margin = Equity – Used margin
Free margin = $1,500 – 1,052.56 = $447.44
Equity is the sum of the account balance and floating profits or losses. It is equal to the account balance when there are no open positions. But with open positions, the floating profits or losses are normally updated in real-time on most trading platforms. The profits or losses are only locked-in when the trader closes all open positions.
From the example above, assuming that at a time, the GBPUSD trade moves 50 pips in favour of the trader, and the USDJPY trade suffers a loss of $35, we estimate the equity as follows:
Equity = Account balance + Floating profits or losses
Equity = $1,500 + $50 + (-$35) = $1,515
Note that this is an estimate and the trading fees or commissions were not factored into the calculation.
The margin level at any time measures the percentage of funds available for opening of new trade positions. The higher the margin level value, the more usable margin the trader has and vice versa. Let us calculate the margin level for the above example, at the time where the equity is $1,515:
Margin level = (Equity / used margin) X 100
Margin level = (1,515/1,052.56) X 100 = 143.93%
In margin trading, the margin level is very important because most trading platforms will not allow you to open more trades once it drops to 100%. A 100% margin level means that there is no more free margin. The margin level is always calculated and displayed on the trading platform. When there are no open trades, the margin level is zero.
Margin call level
This is a threshold of the margin level at which the financial service provider issues a margin call. A margin call is a notification by your Advisor or financial service provider to add more funds into your account or close losing trades because the floating losses have exceeded the used margin. The notification is mainly by email or text message. Some financial service providers set the margin call level at 100%. Once a trader’s margin level drops to 100%, a margin call is triggered. Most learning resources warn traders to avoid margin calls as it evokes emotions and also cause psychological discomforts which are not needed margin trading.
Stop out level
Stop out level is a specific percentage level at which the financial service provider automatically starts closing some or all of the trader’s open positions to curb further losses. It is usually below the margin call level. For example, a financial service provider may set its margin call level at 100% and stop out level at 20%. Once this level is reached, the liquidation process starts with losing trades and continues until the margin level moves up significantly above the stop out level.
Risks of margin trading
One major disadvantage of margin trading is the risk associated with it. The smaller the margin required, the greater the risk to the trader’s capital. As margin enables a trader to open large trade positions, profit is amplified and the same goes for losses. For example, a trader buys 1 lot of EURUSD on a margin of 1% with required margin of $2,000. Each pip increment in price is $10 and each pip decrement in price is also $10. So, a sudden market reversal of 60 pips leaves the trader with a loss of $600.
Margin trading enables a forex or CFD trader to open trade positions greater than his balance after he makes a good faith deposit. When a trade is in progress, the used margin is locked by the financial service provider while the free margin is available to open more trades. The margin level at any time is the ratio of the trader’s equity to the used margin expressed in percentage. Once it reaches the predefined threshold, a margin call which is a call to action is issued to the trader. If the losing spree continues, the margin level reaches a stop out level where the trader’s assets are systematically liquidated.
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Below are some reasons why you should trade with R1Investing :
- Over 350 CFDs on assets.
- Up to 1:500 leverage for professional traders.
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- Tight spreads depicting low trading fees.
- Multiple training resources especially for beginner traders.
What does margin trading mean?
Margin trading means that you only have to deposit a little percentage of the total cost (notional value) of a trade in order to open the full trade position. For example, to open a trade worth $120,000; a financial service provider like R1investing might just require a deposit of 0.5% from a professional trader. So, the pro trader only needs to deposit $600 (being the margin) in order to open a trade position worth $120,000.
Is margin trading a good idea?
Margin trading carry a huge risk to your capital and may not be suitable for some investors or traders especially newbies. This is because it is capable of magnifying both profits and losses. At the same time, it may be a good idea to an experienced trader with limited trading capital, articulated trading plan and excellent risk management strategies. In day trading, margin or leverage trading is utilized since the trades are short term not exceeding a day and the trader aims to capture as much profit as he can.
What triggers a margin call?
In margin trading, a margin call is triggered mainly by losing positions; if the trader’s equity falls below the used margin. The margin call level is set by the financial services provider and it is measured as a percentage. Several financial service providers set the margin call level at 100%, that is, the point where the trader’s total equity is equal to the used margin and the free margin is equal to zero.
What happens if you can’t pay a margin call?
Assuming a margin call is issued to a trader and he or she could not top up his account and perhaps, he believes that the market will reverse in his favour and so decides to leave all positions open. If the trader is wrong and the losses keep accumulating, the margin level will keep reducing until it reaches the stop out level threshold. Automatically, the financial service provider begins to close the losing positions until the margin level is raised significantly.
How do I increase my free margin?
Free margin is the usable margin in a trader’s account that can be used to open more positions. When on a losing trade, the margin level, free margin and the trader’s equity keeps reducing. To increase the free margin, close losing positions or add more funds to the trading account.