Getting your head around how margin works, and the different subdivisions it has in forex can be an exercise even for those gifted in math.
To complicate matters further, there are a lot of margin calculations which aren’t used in your day-to-day forex trading. And it’s not practical to worry too much about them!
So, let’s figure out what’s need-to-know information about margins, and how to use it to improve your forex trading results.
If you’ve already opened your FX trading account, you know what margin is. But the purpose of this article isn’t to repeat theory, but rather to have a look at the practical concepts that you can incorporate into your daily forex trading.
Margin Isn’t Just a One-Off Decision
So, when you open your account, you decide on how much leverage you want.
After that, you typically don’t change your margin. This can lead some FX traders to forget about it. But it has a direct impact on how much you can trade.
There are other articles that get into the mechanics of leverage and margins, but the practical effect is that your account leverage shows how much you borrow from your forex broker each time you open a trade.
For example, if your leverage is 1:100, that means for each $1 that you put up for trade, your broker will “loan” you $99 so you can trade $100.
This is important because a 1% move with $100 is very different than with just $1. Leverage is how you can make (and lose) a lot more in the forex markets by putting relatively small amounts of money in your account.
The thing with this “loan” that your forex broker gives you when you trade, is that, if the trade goes in your favor, everything is fine.
When you close the trade, you pay back the “loan” and take the profit. But, if the trade goes against you, then you start losing money.
The forex broker knows you can pay the amount that you’ve put up for the trade, and in order to make sure you don’t lose more than that, typically will close your trade in order to recover the “loaned” money.
This is known as a “margin call”. So, the amount of money you put up for a trade is how much “margin” you have for market moves against you. Using our 1:100 leverage example, if you put up $1 to trade, you can take a $100 position.
If the market goes down by 0.5%, that means you’ve lost $0.50. It’s still within your “margin” of $1; but if the market goes down by 1%, then you’ve “lost” $1, and your broker will call the trade off, so you don’t start going into negative.
The Whole Account is in Play
Generally, forex brokers try to give you a little extra leeway with your trades by doing the complement of that principle. So, when you enter a trade, the FX broker “locks” in that amount and the rest of your account acts as margin.
Practically speaking, let’s say you have $50 in your account, and take a $2 position. At 1:100 leverage, it means you can buy $200 in the market. That $2 gets “locked” by your broker to cover your current trade, and the remaining $48 is called your “free margin”. That’s how much is still available in your account to put up to trade.
If the market goes in your favor, your portfolio equity increases, and you have more margin available. That is, you have more free margin. And if the market goes against you, then you have less equity available, and therefore less free margin.
Keep an Eye on the Gas Tank
If an analogy helps understand this, let’s turn to cars. Leverage would be like the size of your engine: the bigger it is, the faster you go, but the more gas you need.
Your gas tank would be like your free margin. If you go fast (open a lot of trades) you use up more margin. If you have a smaller engine (lower leverage) then you use less gas. And, of course, if you run out of gas, then your car stops – just like your forex trading stops when you run out of margin!