Margin Trading in the Forex Market

Teaching Margin trading and its terms, reviewing the advantages and disadvantages of these trades and their connection with leverage in the forex market.

Teaching Margin trading and its terms, reviewing the advantages and disadvantages of these trades and their connection with leverage in the forex market.

Contents

What is Margin Trading?

Margin trading is one of the forex market's key features that allows traders to control positions greater than their actual account balance. This type of trading allows traders to increase their potential profit but also increases the loss possibility. It is necessary to review the margin trading terms and tools in Forex to understand margin trading.

What is Margin?

Margin is the amount of money or security deposit that the broker receives from the trader to execute the transaction, and this amount is returned to the trader's account after the transaction ends. Every position opened in the market has a specific amount of margin, which the broker locks until the end of the transaction. Note that the margin is not a payment or a transaction fee but only a type of collateral used to open a trade. For example, a trader with a $1,000 balance wants to make a 1-lot buy trade in EURUSD. The margin Trendo broker receives from the user with a 1000 leverage for this transaction is $100. Note that this security deposit is not cut from the user's balance, meaning the user's balance is still $1,000. But for the new transactions he wants to open, he has $900 free money, which is called free margin. The user's $100 was paid as a margin for the EURUSD transaction.

What is the Required Margin?

The required margin is the money set aside and locked when opening a trade. That is margin in short. The required margin can differ according to the traded currency pair, the trading volume, and the broker's rules. Major currency pairs such as EUR/USD or GBP/USD usually require less margin. The reason for this is the main currency pairs' liquidity and stability. Sometimes the required margin is stated as a percentage of the total trade value. For example, if the margin requirement is 2%, it means a trader must deposit 2% of the total trade value as a margin. If a trader wants to open a position worth $100,000, he must deposit $2,000 as a margin.

What is Leverage's Role in Margin Trading?

Understanding the concept of leverage is essential to better learn about margin trading. leverage allows traders to control bigger positions with less capital. Leverage is stated as a ratio such as 100:1 or 500:1, which defines the amount of assets a trader can manage compared to his initial investment. For example, with a 100:1 leverage ratio, a trader can control a position worth $100,000 with only $1,000 of capital. Leverage allows traders to gain significant profits potentially, but also increases the risk of loss. Therefore, proper risk management is crucial when trading with leverage.

Leverage is credit given by the broker to the trader so that the trader can make trades with a higher volume and several times his balance. The higher the account leverage, the less required margin is needed for the transaction. For example, to buy 1 lot of USDJPY with a $500 margin, you need a $200 margin, and with a margin of $1000, you need a margin of $100. Users with higher leverage can trade more volume.

Read More: What is a Forex Broker?

What is Free Margin?

Free margin is the amount that traders can trade with. It is the amount of money the broker receives as a deposit and margin for executing a transaction which is deducted from the free margin. For example, a user has a $1000 balance and $1000 of free margin for trading, and he plans to buy 1 lot of USDJPY in his account, which has a 1000 leverage. The required margin for this trade in Trendo Broker is $100, so after the transaction, this user's free margin will be $900, but the balance is 1000.

Margin levels

Brokers use Margin levels to determine whether a trader has enough capital to maintain their open positions or not, and are calculated by dividing the equity in the trading account by the margin required for open positions. Margin levels are stated as a percentage. For example, the user's account balance is $1000, and he has made transactions that used a $30 margin, and the result of these transactions is $200 in loss after a few hours, so the user's account balance is $800. We can obtain the margin level (400%) by dividing the remainder by the margin.

When the margin level falls below a certain point due to losses, usually around 50-100%, the trader might receive a margin call from the broker. A margin call requires the trader to deposit more funds into his account or close some of his open positions to bring the margin level to an acceptable level.

Read More: What is Margin Call and Stop Out in Forex?

Now that we learned about the margin trading terms and tools in Forex, let's fully comprehend margin trading with an example.

A margin trading example & the connection between margin and leverage

Further, we will explain margin trading, the margin required for trading, and the free margin and their relationship with leverage as an example. Suppose a trader in Trendo has a $1000 capital, so the free margin is $1000.

The trader has purchased gold with a 0.5 lot volume in his account with a leverage of 1000:1. As seen in the picture, a $96 margin (9.6% initial free margin) was spent on this transaction. In other words, for every 0.01 lot of gold purchased (minimum trading volume in Forex), a $1.92 margin is required. As a result, now that his trade is in profit, the trader's free margin is $909.32. If the trader wants to calculate how many more lots he can buy in gold, he has to divide his free margin by the required margin for buying 0.01 lots of gold. Therefore, this trader can trade another 4.73 lots in gold with this free margin. Note that the higher the account leverage, the less margin is needed for trading. As a result, the trading volume can be higher. The higher the trading volume, the higher the trading risk. Read the following example to understand this.

Let's assume that the same trader has purchased gold with a 0.5 lot volume in his account, but this time with a 100:1 leverage. A $962 margin (96% of the initial free margin) was used for this transaction, as seen in the image. For every 0.01 lot of gold purchased (the smallest trading volume in Forex), $19.2 of margin is spent, and in 100:1 leverage more margin is required for trading than in 1000:1. As a result, there is little free margin left for a new transaction, so now that his trade is in profit, the trader's free margin is $65.98. If the trader wants to calculate how many more lots he can purchase in gold, he has to divide his free margin by the required margin for 0.01 lot of gold purchase. Therefore, this trader can trade another 0.04 lots in gold with this free margin.

As mentioned in the above example, in margin trading, the relationship of margin required for trading with leverage is the opposite. That means, the higher the account leverage, the less margin is required for the trading. Therefore, a higher trading volume can be carried out.

Margin Trading Advantages

Increased Profit Potential: Margin trading allows traders to control positions much bigger than their account balances, meaning they can potentially make more profits. Even a small price movement can lead to significant gains when trading on margin.

Diversity: Margin trading helps traders to diversify their portfolios by opening multiple positions in different currency pairs. This diversification can help spread risk between different positions, potentially increasing the odds of profitable trades.

Less capital required: Forex brokers usually offer high leverage ratios allowing traders to participate in the market with relatively little funds. This accessibility makes the forex market attractive to beginners with limited capital.

Margin Trading Disadvantages

Increased losses: While margin trading improves potential profits, it also increases the chance of losses. The loss can increase accordingly when the trade goes against the trader's analysis. Traders must be attentive and use risk management strategies to protect their accounts.

Margin call: Margin call occurs when the loss of transactions in the user's account is higher than the level known as the margin call level. In such cases, the user cannot open any new trade because he doesn't have a free margin. The gross margin level can differ for different brokers. Note that many traders confuse a Margin Call with a Stop Out and think that a Margin Call means that the user's trades are closed, but a Margin Call is a warning saying you aren't allowed to open a new transaction due to the high loss of transactions in progress.

Stop Out: If the user's transactions lose so much that his account's stop-out level is activated, the user's transaction or open trades are automatically closed by the broker, which prevents the user's balance from becoming negative.

Volatility Risks: Forex markets can be highly volatile, and unexpected price changes can lead to significant losses. Traders should grasp market volatility and use appropriate risk management tools, such as stop-loss orders to minimize potential losses.

Margin Trading Tips

Below are some crucial tips for beginners wanting to trade on margin:

• Learn: Before diving into margin trading, learn its concept, risks, and benefits. Take advantage of the many available educational resources, such as online courses, books, and webinars.

• Start with a small capital: Start with a demo or a real account with a small balance to gain practical experience without risking significant assets. That will allow you to accustom yourself to the platform, practice risk management, and develop your trading strategy.

• Understanding risk management: Create and strictly stick to a risk and capital management plan. Set limits on the maximum leverage amount you are willing to use and specify your trading account's maximum percentage you are ready to risk on a single trade.

• Monitor Margin Levels Regularly: Observe your margin levels to avoid margin calls and stop-outs. Regularly assess your trading account's health and adjust your positions accordingly to maintain sufficient margins.

• Seek professional advice: Seek professional advice: Seek tips from experienced traders or help from a professional financial advisor. They can provide valuable insights, help you improve in the forex market, and give advice on risk management strategies.

Summary

Margin trading can be a powerful tool for forex traders, allowing them to maximize potential profits and access higher positions. However, it is essential to understand the difficulties of margin trading, its risks, and its benefits. You can successfully navigate the margin trading world by learning, practicing risk management, and seeking professional advice.