What is margin in forex? This is a question that normally arises when margin trading is being referenced.
People have been asking questions like “what is margin in trading,” “how margin trading works,” “what is a margin call in forex,” and “is margin trading worth it” among others on numerous occasions.
For this reason, I have decided to delve into the topic.
What is Margin?
Margin has two major definitions. In the first definition, margin refers to the ratio of profit to revenue.
In the second definition, it refers to money that is borrowed from a brokerage firm for leveraging an investment.
In trading forex, you are only needed to invest a little capital to open and manage a new position.
This invested capital is referred to as the margin.
The second definition seeks to answer what is margin in forex trading.
For instance, when you wish to buy $120,000 worth of EURUSD, you are not required to avail the entire amount. You might require a small amount like $3,500.
The exact amount is determined by the CFD provider or your forex broker.
You can think of margin as being good faith deposit or as collateral required to open a trade position and maintain it that way. Margin is not the same thing as a fee or transaction cost.
It is basically some of the money that is put aside from your account by your forex broker to maintain your open trade and make sure that you take care of the possible loss that might be encountered as a result of the trade being open.
Margin trading is a way of trading assets with the use of funds from a third party.
Compared to regular trading accounts, margin accounts make it possible for traders to have access to more capital and thus have them leverage their positions.
Generally, margin trading tends to magnify trading results to help traders generate more profits on good trades.
This factor of widening trading results makes margin trading particularly famous in low volatility markets, especially the forex market, which is global.
Margin trading is additionally used in stock, crypto currency markets and commodity.
In the original markets, borrowed funds are given by an investment broker.
However, in cryptocurrency trading, funds are given by other traders who generate interest depending on market demand for margin funds.
There are cryptocurrency exchanges that also offer margin funds to users, even though this is not so common.
What is a Free Margin in Forex?
I know you have encountered the concept of free margin in forex while undertaking your trading endeavors.
Free margin is the sum of money that is not spent in any form of trade.
This money can be used to take more positions and is also the variance between available equity and margin.
When you are able to earn money from your open positions, the more profit they generate, the greater your equity becomes and as a result, you will have additional free margin.
A situation may arise where you have some open trade positions and pending orders.
The market therefore wants to trigger one of your pending orders but your account may have less forex free margin.
In this case, the pending order will not be triggered or will get cancelled all together.
Due to this, you may find yourself accusing your broker of not executing your orders, but this is not the case.
How a Broker Benefits from the Margin
Brokers do not directly gain from the margin, but they tend to get some indirect benefits.
In one instance, the margin simplifies the way you are involved in the forex market as a trader.
It does not eliminate the risks involved but then the more a broker encourages you to keep trading through making things easy, the more you keep at it.
Secondly, the more you trade especially with larger amounts, the more the brokers can gain added commissions and maybe profit from the forex spread markups.
In simpler terms, the greatest gain for a broker in margin trading is that a trader will trade more both in terms of volume and frequency.
Advantage of Trading on Margin
The greatest advantage of trading margin in forex is that you are able to generate more gains as compared to your account balance.
In an example, maybe you have a $2000 balance in your account and you are not trading on margin.
You start a trade that takes up 200 pips.
In a $2000 trade, every pip costs 10 cents. The profit your trade generates would be $10 or a 0.5 percent gain.
In case you used the same amount and you have a 40 to 1 margin trade offering, you now have a trade value of $80,000, the 200 pips would now net you $400 or a 20 percent gain.
Disadvantage of Trading on Margin
Risk is the main disadvantage when you are trading on margin.
I will try and elaborate this by making a reverse assumption to the example that I have provided above.
With a $2000 account balance, you start a $2000 trade and lose 200 pips.
This loss is only $10 or 0.5 percent.
This does not sound so bad and you will still be left with enough capital to try again.
When you happen to make a 40 to 1 margin trade for $80,000 a loss of 200 pips assumes $400 or 20 percent of your total capital.
If you engage in another similar trade, then you will have like 60% of the original amount left in your account.
From the first example, your loss was just $10 or 0.5 percent, you would be required to make such a losing trade like 198 times for you to blow your account, but would only take 5 trades to blow your account when you are trading with the margin.
This is a good example to showcase the inherent margin trading risk.
What is a Margin Call?
A margin call, well known as a maintenance call is when your trading broker requests that you add more money to your margin account since the value of your account is dropping.
This is possible as soon as the value of your account’s equity drops past a certain level, caused by a drop in price.
Brokerages basically need a 25 percent baseline, to mean you should have a minimum of 25 percent equity of the entire market value of securities in your trading account.
It is not necessary for your brokerage to inform you of a margin call even though many will make an effort of contacting you through email or phone.
They also don’t require to give you time to increase money in your account although some do that.
If a margin call is given and you are unable to meet the minimum investment criteria, the broker has the right to sell the positions and charge you certain commissions, fees, and interest.
Conclusion on What is Margin in Forex
Margin trading is simply another tool in forex.
It can be used to make good gains as well as risk excess loss.
Trading on margin requires a good level of expertise and a strict risk management strategy for it to be effective.
I hope now you are aware of what is margin in forex.