Margin call, a term often met with dread, carries with it some heavy-duty meaning in forex trading.
A margin call occurs when a trading account no longer has any free margin. It is a request from the broker to bring margin deposits up to the initial margin level, also known as deposit margin, to keep existing positions open.
Trading on margin offers a variety of benefits, as well as some additional risks, including margin calls. In order to avoid receiving a margin call, knowing how to define margin and leverage, often misunderstood concepts, is essential.
Understanding the Lingo
Understanding terminology helps the forex trader categorise trading positions and communicate with forex brokers.
The forex account balance, as shown in figure 1.A, is a touch under £100,000. A small real time long position is active: 10,000 units of GBP/USD, filled at 1.28743.
The account equity is below the account balance due to the position trading in minor drawdown. Account equity will fluctuate until the trade closes. The balance, although remains at £99,827.96 during the trade, will reflect the position’s difference once all trades are settled.
Forex Margin, or initial/used margin, is £10, and is the amount of money the forex broker sets aside in order to take the position. This does not fluctuate during the trade and will represent 0 (and is returned to the account balance) once the position settles. Free margin (also known as usable margin or available margin) currently stands at £99,817.87 – the amount of account equity not used to maintain the open position (the initial margin) and the amount available to open additional positions. It’s also the value the current position can move against you before the account receives a margin call.
As long as the equity level remains above margin, the account will not receive a margin call.
Margin and Leverage in Forex
Margin and leverage are closely related themes, both essential understanding for risk management.
Margin is employed across several financial markets; how margin trading functions in the equities market, though, is different from the foreign exchange (forex) market. Purchasing stock on margin involves borrowing money from your broker. Unlike margin in stock trading, the margin in foreign exchange is not borrowed money. Nothing is bought or sold, only the agreement to buy or sell is exchanged.
Margin is a good-faith deposit required by brokers to open and maintain positions in the forex market. It’s there to safeguard each party within the agreement. If you buy $100,000 worth of currency on margin, you are not depositing $1000 and borrowing $99,000 for the purchase. The $1000 is there to cover your losses within the specified agreement.
Currency pairs, aside from ones containing the Japanese yen, move very little – it takes a market move, in USD, of 10,000 pips to equal $1. Without margin accounts, therefore, the world of foreign exchange is too expensive for most traders.
Leverage represents a ratio. 1:100 leverage, for instance, means for every $1 trader are able to control up to $100. Leverage, dependent on your broker, typically ranges from 1:1 to as much as 1:500, but this does not mean you should use all the available leverage, quite the contrary.
- 1:1 leverage means having a 100% margin requirement (equivalent to no leverage).
- 1:2 leverage means having a 50% margin requirement.
- 1:100 leverage equates to a 1% margin.
- 1:500 is 0.002% margin.
As you can see, the leverage the broker allows controls the margin you must maintain.
Leverage is also inversely related to margin:
- A 1:100 leverage ratio has a margin percentage of 0.01, or 1% (1/100).
- A 1:50 ratio has a margin percentage of 0.02, or 2% (1/50).
- If the margin requirement is 2% then leverage is 1:50 (1/0.02)
After placing a trade, a percentage of the account is put on hold for each lot of currency traded. This is a used margin.
If you traded 1 standard lot of EUR/USD without margin, you would need $100,000 in your account. But with a margin requirement of 1% (1:100 leverage), you would only have to deposit $1000 in your account to control a 100k position. Margin requirements differ from broker to broker.
The margin requirement can also be satisfied not only with money, but also open profitable positions.
Units Traded * Current market Price * Margin
- 100,000 * 1.20 (GBP/USD market price) * 0.01 (1:100 leverage) = $1,200.
$1,200, in this case, is the margin. Assuming a $10,000 account, the free margin is £8,800.
- 100,000 * 1.30 (EUR/USD) * 0.002 (1:500 leverage) = $260.
$260 is the margin cost to trade 1 standard lot at a trading price of 1.30, leaving traders with a free margin of $9,740 ($10,000 account size).
The above assumes a USD-denominated account. If the base currency is the same as the account currency, simply multiply units traded by the margin requirement.
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