Forex Trading On Margin

Forex trading on margin accounts is the most common form of retail forex trading. This article explains what ‘margin’ is, shows a margin calculator or ‘formula’ and how to use this free margin safely. Understanding margin requirements, and how leverage levels affect it, is a key part of trading forex successfully.

Margin Definition

In the trading world, a margin account involves borrowing in order to gain a greater potential ROI (return on investment). Many investors make use of margin accounts when implementing a strategy to invest in equities using the leverage of borrowed money.

This enables them to control a greater position than their own invested capital would.

Margin accounts are operated by the investment broker, and are settled in cash each day. Equities are not the only investment type that margin accounts are suited to – currency traders in the forex market regularly use them too.

To begin, forex traders need to sign up with their preferred broker. Once they are registered, they will need to set up a margin account.

A margin account in forex is very similar to one for equities – in a nutshell, the investor takes out a short-term loan from their broker.

The size of the loan is equal to the amount of leverage the investor takes on.

The core meaning of leverage is the ability to control large amounts of money using very little of your own capital and borrowing the rest. Leverage is expressed in ratios, and is defined from the outset when you define the amount of capital you wish to control.

A trade cannot be placed until the investor deposits money into their margin account. The amount that must be deposited depends on the margin percentage that is agreed for the leverage.

Interest / Rollover

No interest is directly paid on the borrowed amount, but there will be a delivery date attached, and if the investor fails to close their position in time then it will rollover.

In this case, there may be interest charged depending on whether the investor’s position is long or short, as well as the short-term interest rates of the currencies in question.

The money the investor puts into the margin account acts as a security deposit of sorts for the broker. If the investor’s position worsens and a loss looks likely, the broker may make a margin call. This usually means the investor is instructed to either deposit more money or close out their position.

The purpose of this is to minimise the risk to both parties.

Margin Explained

Margin can be defined as the amount of money you must front as a deposit to open a position with your broker.

The broker uses this deposit to maintain your position. Margin deposits are usually taken from clients and pooled together for a fund to place trades within the interbank network.

Margin will typically be expressed as a percentage of the full amount of a position. The majority of forex brokers will require anything from a low margin of 0.25%, 0.5%, 1% or 2% up to higher-level margins.

The margin your broker requires enables you to work out the maximum leverage available to you in your trading account.

Let’s say your broker requires a 1% margin to control a £100,000 position. This will mean that your broker sets aside £1,000 from your account, and the remaining £99,000 will be supplied as leverage.

This a margin of 1% and a leverage of 100:1, and you are using margin to control currency to the sum of £100,000. That £1,000 deposit you contribute is the margin you give in order to be free to use the broker’s leverage.

If your broker requires a 2% margin, the leverage will be 50:1. A 5% margin means leverage of 20:1, and so on.

This primary definition of ‘margin’ is common to all accounts, but you will probably see other ‘margin’ terms on your platform. In addition to margin requirement, you may also see:

  • Used margin: This is the money the broker has locked in to keep your current positions open.
  • Usable margin: This refers to the money in your account that can be used to open new positions.
  • Margin call: This happens when the money you have in your account is insufficient to cover your possible loss.

Forex trading on margin

Accounts

You can expect the type of account you hold with a broker to have an impact on the available margin and leverage.

If you hold a standard account only with a broker, the available leverage is likely to be considerably lower, and the margin required to secure that leverage will be higher.

This is because you are likely to be less experienced and working with smaller amounts of money than those who hold higher-level accounts, such as professional and VIP.

Brokers take on a certain amount of risk with every client, and when engaging in margin trading the risk to the broker is higher.

There is likely to be more faith with clients who hold a higher-level account, so superior margins and leverage will be available. In short, the more prestigious your account type with the broker, the better your ratio of leverage to margin will be.

Trading Without Margin

When you trade without margin, all transactions must be made with either available cash or long positions. So whenever you buy a position without margin, you must deposit the cash required to settle the trade, or sell an existing position on the same trading day.

In other words, cash proceeds must be available to settle the buy order directly – it’s a straightforward approach but somewhat limited.

The pros of trading without margin are as follows:

  • 1. Less Risk: Margin trading can lead to greater profits, but it can also cause greater losses. Trading without margin exposes you to less risk, and although the potential profits are smaller, with a good strategy you can make healthy gains.
  • 2. Less Stress: Having larger positions open can be extremely stressful and sometimes causes people to make poor decisions. The fluctuations will look much bigger with margin trading, while smaller positions without margin will feel safer, more secure, and ultimately less stressful.
  • 3. No Margin Calls: A margin call is the nightmare of anyone trading on margin. When you trade without margin, there is no risk of this occurring, giving you peace of mind and helping you feel more in control of your own destiny.

The primary benefit of trading without margin is the decreased risk. There are many benefits to trading with lower risk, not least of which being your own peace of mind.

If stress and anxiety are problems for you, and taking a big financial hit would be very damaging to your life, then you may be better off trading without margin.

The cons of trading without margin are:

  • 1. Less Buying Power: The most obvious disadvantage of trading without margin is that you will be able to control less currency, and thus your buying power is far lower. By borrowing from your broker, you can control significantly larger positions and boost your potential profits by a huge amount.
  • 2. Less Flexibility: By having less capital at your disposal, you will have less flexibility to quickly build a portfolio. If your account only enables you to take up 1 position at a time, it’s going to take a long time and a lot of work to build up a portfolio. Trading on margin opens up more doors, giving you the flexibility you need to diversify your trading instruments.
  • 3. Limited Account Growth: Before margin came into the equation, small traders found it difficult to grow their accounts rapidly. By being limited to your account balance, you will probably have to focus on slow and steady growth over a long period, whereas trading on margin gives you the power to grow at an exponential rate with a relatively small investment from your own funds.
  • 4. More Personal Capital Required: Without leverage from your broker, you are going to need to invest more of your own money to see the profits you need to grow and sustain your career as an investor. The margin required by brokers can be very small, giving you access to a large fund that you can use to grow and secure your trading future.

Though the risks are greater, the potential gains associated with trading on margin are what makes it a good choice for many investors. Trading without margin is restrictive, and though you can make a success of it, you will likely be in for a much slower and longer journey to where you want to be.

Both methods are valid ways of building your investment portfolio, but it’s down to you to judge which is a better fit for you.

Margin Calculator

One of the most important things to do when weighing up whether to trade with or without margin is to understand how much leverage will be available for a given margin.

Busy traders need to get a clear picture of what’s available as quickly as possible.

XM offer a great margin calculator across all currencies and forex pairs, Use it here

In order to work out your capital requirements ahead of time, here is the formula:

(Exchange rate * unit per pip) * leverage

The exchange rate is the whole number, with no decimals. The unit per pip is the amount you want to risk / make on each pip of the exchange rate movement. Leverage is the ratio that brokers will offer to you – but here we need to convert it to a percentage, or decimal. So 1:10 would become 0.10, 1:30 wold become 0.033 and 1:200 would become 0.005 (as examples).

Let us look at a full example.

We will trade GBPAUD for £1 a point (pip). We will say the rate is 1.9350. The leverage will be 1:20

So our calculation is:

(19350*1) * 0.05 = 967.5

So you would need £967.5 in your trading account to open this position.

Let’s tweak some number and see what changes. Firstly, let’s be bold and risk £5 per point. Secondly, lets use a broker that offer 1:200 leverage:

(19350*5) * 0.005 = 96.75

Now you need just £96.75 to open this position – even though the trade is 5 times as big at £5 per point.

The first part of the calculation is your overall exposure – the amount of currency you are buying in effect. Here is one last example:

Here we are trading BTCGBP – Bitcoin – again, £1 a point, this time with leverage of 1:2 (This is the level most EU brokers will offer on Crypto currency). We will say the exchange rate is 9650:

(9650*1) * .5 = 4825

So here, we need to put down far more capital than a major forex pair. This reflects the volatility and risk the broker is taking, effectively lending money on this asset.

We have used GBP in the examples, but the same formula and calculation applies whether trading EUR, USD or any other currency.

Margin Call

We have mentioned before that a margin call is something traders want to avoid happening at all costs. Let’s take an in-depth look at what it means and why you don’t want it to happen.

Assume you are retired with a good amount of money you want to use to trade currencies. You open an account with a broker and deposit £10,000.

When you log in, that £10,000 appears in the Equity column in your Account Information.

You see that there are also columns for Used and Usable Margin – the amount under Usable Margin is always equal to your Equity minus the Used Margin. Equity, rather than Balance, is used to determine your usable margin, and it will also determine whether or not a Margin Call occurs.

Simply put, as long as you keep your Equity higher than your Used Margin, a Margin Call will not occur. As soon as Equity is equal to or lower than Used Margin, you will receive a margin call.

Imagine your margin requirement is 1%, and you decide to purchase 1 lot of GBP/USD. Your Equity will remain at £10,000, and your Used Margin will now read £100.

Usable Margin now stands at £9,900.

If you sell back that 1 lot of GBP/USD at the same price you bought it at, the Used Margin would return to £0 and Usable Margin would go back to £10,000.

If, however, you decided to buy a further 79 lots of GBP/USD, totalling 80, your Equity will remain the same but your Used Margin will now be £8,000.

The Usable Margin will now stand at £2,000. This risky move could yield an enormous profit if GBP/USD rises, but if it falls then you will see your Equity fall along with it.

The Used Margin will remain at £8,000, but as soon as the Equity drops below £8,000 you will have a Margin Call.

This will mean that some or all of your position will be immediately closed at the current market price. This will mean a considerable loss to you, and is the reason why taking big risks is never a sensible approach when trading on margin.