As we discussed in the previous chapter, when trading Forex, you only need to put down a small amount of capital, also known as the margin, to open a new position. This type of trading is known as margin trading and is one of the key reasons why many traders are specifically drawn to trading the forex market.
In simple terms, it is a portion of your funds that your broker sets aside to ensure that you can cover the potential loss of the trade. For example, if you want to buy $100,000 worth of USD/JPY, you don’t need to invest the full amount. Instead, you only need to deposit a portion of the margin required by your forex broker (depending on your Forex broker and leverage).
This portion is ‘locked up’ by your broker for the duration of the specific trade. Once the trade is closed, the margin is released back into your trading account and you can now use it again… to open a new trade. This is, in a nutshell, how margin is used in the Foreign Exchange market.
In this lesson, we’ll help you figure out what is margin in forex and how you can effectively use leveraged trading in the forex markets.
Margin is usually expressed as a percentage of the full amount of the position. For example, most Forex brokers say they require 0.25%, 0.5%, 1%, 2%, 10% or 25% margin. And, when you trade forex, this percentage is known as the Margin Requirement.
Here are some examples of forex margin requirements for different currency pairs:
As you can see in the above, the forex margin requirement for the EUR/USD is just 2%, which means the broker provides a leverage ratio of 50:1. For that matter, some forex brokers provide even a higher leverage ratio of up to 500:1 and even 1000:1. With that said, these ratios also significantly increase the risks involved in trading currency pairs and trading CFDs.
When margin is expressed as a specific amount of a trader’s account balance, this amount is called the required margin. Each and every position you open when trading Forex will have its own required margin amount that will need to be locked up. This margin level varies depending on the currency pair you are trading and the financial instrument you decide to trade (most brokers also offer trading CFDs).
For example, to buy or sell 100,000 of GBP/USD without leveraged forex trading would require the trader to put up the full value of the position as an initial investment – $100,000. But with a margin requirement of 5%, only $5,000 (the required margin) of the trader’s funds would be required to open and maintain that $100,000 GBP/USD forex trade.
If the base currency is the same as your account’s currency, this is the formula to calculate forex margin:
Required Margin = Notional Value x Margin Requirement
However, if the base currency differs from your account’s currency:
Required Margin = Notional Value x Margin Requirement x Exchange Rate Between Base Currency and Account Currency.
If you still find it difficult to understand how forex margin works, let’s take two forex trading scenarios as examples.
Let’s say you’ve deposited $1,000 in your account and want to go long (buy) GBP/USD at 1.3100 and you want to open 1 mini lot (10,000 units) position. How much margin will you need to open this position?
Since GBP is the base currency, this mini lot is 10,000 pounds, which means the position’s notional value is $13,100. Assuming your trading account is funded in USD and the margin percentage requirement is 5%, then the margin required in order to this position will be $655. In this case, the used margin in your trading account balance would be 65.5%. Leaving the account with a free margin of 34.5%.
Now, let’s say you’ve deposited $1,000 in your forex trading account and want to go long (buy) EUR/USD and to open 1 mini lot (10,000 units) position. How much margin will you need to open this position?
Since EUR is the base currency, this mini lot is 10,000 dollars, which means the position’s notional value is $11,900. Assuming your trading account is denominated in USD, and since the forex margin requirement for this trade stands at 2%, the margin requirement for this trading position will be $238.
To sum up, margin trading is a way for forex traders to boost their purchasing power and to increase potential profits. It essentially enables you to use someone else’s capital to be able to trade forex with more money than initially deposited. However, you should also remember that because brokers in the forex industry offer extremely low margin requirements (and very high leverage ratios), then trading with margin carries significant risk. Unlike the stock and commodity markets, the initial margin requirement in the forex market usually starts at around 3%. Clearly, when using this high leverage, you increase the chance to face margin calls and ultimately, to lose your money.
To solve this high-risk issue, you always need to use risk management tools and find the forex margin level that is good for your trading style. Beyond that, you need to be alert to a margin call that occurs when your forex trading account falls below the maintenance margin requirement provided by your broker. What’s more? It’s advisable that you use a forex margin calculator before you enter a forex trade, and make sure you know the maximum leverage that your broker offers for the chosen currency pair.
And that’s all there is to know about forex margin trading… for now anyway! In the next chapter, you’ll learn how a currency pair trade works in the Foreign Exchange market.