How does Margin work in Forex

Margin in forex can be likened to a downpayment or deposit placed on a home loan. In forex, it is a percentage of a trader’s funds (amount of money in a trading account) that is set aside when executing a trade order. The usual margin percentages are  0.25%, 0.5%, 1%, 2%, 5%, 10%; percentages can get higher. This percentage is known as an Initial Margin Requirement (IMR). This is not to be confused with Maintenance Margin Requirement (MMR) – explained further in the rest of this discussion.   

One example is when a trader buys the USD/CAD currency pair for $50,000 and they only need to pay $1,000 in order to start trading, or to open a position. In this case, $50,000 X 2% = $1,000. So, here the IMR is 2%. The next question might be what Margin Level and Margin Call are. Their connection and roles in forex trading are explained further below.

On the other hand, an MMR is the amount a trader needs to have in their trading account to avoid a Margin Call.

Margin Calculation

The formula for margin is:

Margin = Lots x Contract Size / Leverage

Example: A trader purchases 2 Standard lots (a Standard lot in forex is 100,000 units) of GBP/USD using 1/100 leverage. Therefore, to calculate the margin for this position:

Margin = (2 x 100,000) / 100 = 2000 USD

Understanding Margin Level and Margin Call

  • Margin Level
    A Margin Level indicates the status of an investor’s trading account. It is similar to when viewing if a trader’s account is in the red or not in terms of the fund balance of a trading account against the funds used on open positions. Simplified in a formula, the calculation is shown below:

    The formula for calculating Margin Level is (equity/used margin) X 100. A trading account’s Margin Level is stated in percentage. Equity in forex is the total value of a trading account which is the amount of margin used on open positions and the rest of the funds remaining in the trading account. For example, a trader opens a forex account with a broker and puts $20,000 (equity) into the trading account and opens one trading position. For this trading position, the broker requires $5,000 (used margin) to maintain the position. So, using the abovementioned formula, Margin Level can be calculated: ($20,000/$5,000) X 100 = 400%.

    These days, trading platforms calculate trading account equity based on several factors. For instance, on the MetaTrader 4 (MT4) trading platform, the factors included in calculating equity will be shown in charts in its terminal window. To understand MT4 better, you can check out some of the ZFX MT4 features.
  • Margin Call
    A Margin Call is a notification or order sent out by a broker to an investor when their trading account funds decreases to below the Maintenance Margin Requirement. It is basically a broker instructing the investor to deposit more funds into their trading account. This Margin Call formula can help with estimating when a broker would make a margin call: Market Value x MMR – Investor Equity = Margin Call. When a Margin Call is issued, an investor can do one of three things:
    1. Deposit more funds into the trading account.
    2. Close or liquidate all or some positions. Then, use the capital gained to lessen or pay the margin owed.  
    3. Ignore the Margin Call and allow the broker to liquidate all stocks.
  • Margin Call Formula Explained (Market Value x MMR – Investor Equity = Margin Call)
    For example, George decides to purchase some shares of Apple stock worth $20,000. He pays $10,000 for the shares and borrows the rest of the $10,000 from his broker. The broker has fixed a Minimum Margin Requirement (MMR) of 30%. Meaning George’s Initial Margin Requirement (IMR) is well above the MMR which is the ideal scenario for a healthy trading account.

    Unfortunately for George, after a week, the Apple stock he bought depreciates in value to $15,000. This means his equity has also decreased to $5,000 (market value – borrowed funds). The 30% required MMR by the broker is now more than George’s equity. So, now that George’s equity is $1,000 less than the 30% MMR, the broker would make a Margin Call for $1,000.

    Calculation:
    $20,000 (market value) X 30% (MMR) – $5,000(Investor Equity) = $1,000 (margin call)

    Any investor would do well to avoid Margin Calls altogether, but in the instance that one is unavoidable, being able to calculate the amount payable will help in minimising losses. This rings true to the idea that Margin Calls, to begin with, are brokers’ way of managing risks so traders don’t rack up losses greater than their trading account equity.

Avoiding Margin Calls: Stop Out and Stop Loss

There are two types of Margin Calls. They are explained below:

  • Stop-Out – A Stop-Out level is when a trader’s open position(s) are forcedly closed due to the trader’s account having insufficient funds. When referring to insufficient funds, it means the trading account’s equity is a certain percentage lower than Used Margin or IMR. This type of Margin Call is one that is intended to protect a trader from more losses. The moment the margin level is at the Stop-Out level, then a broker starts closing the trader’s open positions. The most unprofitable open position will be closed out first and so on and so forth until the account’s margin level rises back up to higher than the Stop-Out level.     
  • Stop-Loss – A trader places a Stop-Loss order with a broker in order to minimise losses. Once it has been placed, a broker would automatically close a position when the currency pair of that position reaches a specific price level. Even though Stop-Losses are usually used to protect a trader’s open long positions, they can also be used for short positions. This type of Margin Call is seen as a safety precaution to reduce the impact of losses on a trader’s forex trading assets.

What is a Margin Account

A Margin Account is opened with a broker which allows the investor to borrow funds from the broker. The cash that’s loaned out to the investor is used as collateral during the purchase of trading assets. This cash loan is called a margin which augments the investor’s purchasing power but also their risk exposure. The reason being, Margin enables a trader to make purchases on larger position sizes.

The upside of trading with a Margin Account is being able to purchase assets at a fraction of the price. For example, if a trader buys assets that has a 5% forex margin it would mean that the broker is providing the trader with 20:1 leverage or control over a trade 20 times larger. The higher the leverage, the lower the margin.

With a 5% forex margin (20:1 leverage), if a trader buys $10,000 worth of Google stock, the trader would have control over a trade value worth of $10,000 X20 = $200,000.

The idea of opening a Margin Account may be exciting as an afterthought. Especially for a trader who is confident in their trading skills. However, margin trading is really only recommended for the most experienced traders who have a firm grasp on the risks and requirements of margin trading.

As an aside, in stocks trading, a Margin Account is not useable on trading accounts with a value of less than $2,000. The same can be said for stock margin trading with an individual retirement account, a trust account and the like.  

Forex Margin Calculator

Calculating forex margin is complex but the good news is that these days brokers either provide forex margin calculators or the margin itself, automatically. For more on the manual calculations of margin and leverage, check it out at this ZFX website. They are a licensed services provider of multi-asset trading.

Understanding Profit or Loss, Used and Free Margin

There are other factors that need to be taken into account for keeping a trading account open or to keep it at the minimum required balance amount. Profit or loss (P/L), Used and Free Margin all affect the balance of a forex trading account. Starting with P/L which can be seen as Unrealised (floating) P/L, or Realised P/L.

  1. Unrealised P/L – Directly relates to a trading account’s open positions, in that, they are realised as soon as open positions are closed. The unrealised P/L is the profit or loss that is held up by all open positions. The reason that it is also called floating P/L is because its value is ever changing for as long as the open positions remain open. These open positions’ values continue to fluctuate or be floating with current market prices. Therefore, an unrealised profit could turn into an unrealised loss if price action moves against your open positions. The same would happen with an unrealised loss turning into unrealised profit if price trends worked in a trader’s favour.  
  2. Realised P/L – This P/L will affect a trading account balance because it changes once a trade is completed. For example, if you were to close a position with a profit (realised), your account balance will increase. Likewise for a realised loss, if you were to a close a position and made a loss, the balance in your account would lessen too.
  3. Used Margin – The sum of Margin that a trader has used for all positions. Used Margin does not factor in unrealised P/L. So, when positions are closed, used margin should decrease accordingly.
  4. Free Margin – This is the useable margin and can be derived when used margin is deducted from equity or in formula: Equity – Used Margin = Free Margin.

By monitoring the 4 account characteristics above, a trader should be able to lower their chances of getting served a Margin Call order.

Final Thoughts

Understanding the different types of margins in forex trading serves two functions. Knowing IMR will help a trader in using leverage to make a profit on trade as much as possible or minimise losses using Stop-Loss and Take-Profit points. Secondly, knowing how to calculate MMR will help a trader avoid Margin Calls from their broker.

All in all, margins are a useful risk managing tool which would especially benefit a beginner trader in transitioning to becoming a seasoned trader.

FAQs

  1. How to calculate margin?
    When a trader buys the USD/CAD currency pair for $50,000 and they only need to pay $1,000 in order to start trading, or to open a position. In this case, $50,000 X 2% = $1,000. So, here the Initial Margin Requirement (IMR) is 2%.
  2. What does 5% margin mean in forex?
    If a trader buys assets that has a 5% forex margin it would mean that the broker is providing the trader with 20:1 leverage or control over a trade 20 times larger. The higher the leverage, the lower the margin.

    With a 5% forex margin (20:1 leverage), if a trader buys $10,000 worth of Google stock, the trader would have control over a trade value worth of $10,000 X20 = $200,000.
  3. Is leverage same as margin?
    No, but they are related. If a trader buys assets that has a 5% forex margin it would mean that the broker is providing the trader with 20:1 leverage or control over a trade 20 times larger. The higher the leverage, the lower the margin.
  4. How do you calculate leverage and margin?
    Margin = 1/Leverage

    Example: A 50:1 leverage ratio yields a margin percentage of 1/50 = 0.02 = 2%. A 10:1 ratio = 1/10 = 0.1 = 10%.

    Leverage = 1/Margin = 100/Margin Percentage

    Example: If the margin is 0.02, then the margin percentage is 2%, and leverage = 1/0.02 = 100/2 = 50.

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