Margin, also known as collateral or deposit, is one of the most important building blocks in Forex trading. Nevertheless, most beginners do not understand this important term or misinterpret it. Fortunately, we can help out in this respect.
What is margin?
What is usually referred to as margin in Forex & CFD trading is essentially a good faith deposit required to maintain an open position. A margin is not a fee, nor is it a transaction cost, but a portion of the equity that is deposited. This equity portion serves as a security deposit. We advise every trader to look into this matter in detail and at the same time point out the possible consequences of trading on margin: Margin trading can have both a positive and negative impact on your trading experience, as significant profit opportunities are matched by significant loss risks.
We therefore advise both newcomers and experienced traders to always use a free demo account. For newcomers, this is important in order to become familiar with both the markets and the trading platform – but also to practice in a risk-free environment under realistic conditions. But even experienced traders can benefit from using a demo account. For example, new strategies or indicators can be tested without the risk of losses before being used for trades with real money.
How does trading on margin work?
Your broker takes your deposit and bundles it with other collateral from other traders. Brokers use this approach to place positions on the entire interbank market. A deposit amount is usually expressed in relation to the total position opened. The majority of margin requirements are estimated at two percent, one percent, 0.5 percent and 0.25 percent. Based on the deposit required by your broker, you can calculate the maximum leverage you can exercise with your trading account.
The link between leverage and margin
In Forex & CFD trading, leverage reflects the margin required to open trading positions. The higher the leverage, the lower the margin required for the position. The leverage effect does not only affect the margin, but also the potential gains or losses.
If, for example, you trade an instrument with a leverage of 1:500, a market movement of only one percent results in a gain or loss of a full 500 percent! The leverage effect therefore enables considerable profits, but also losses, even with a low trading capital.
In this context, the year 2018 brought considerable changes, as in March this year the European Securities and Markets Authority (ESMA) published a new regulation for all CFD brokers in the European Union (EU). The subject of this regulation was in particular the maximum available leverage for private traders (so-called retail clients), which will be set at 1:30 for main currency pairs, 1:20 for other currency pairs, indices and gold and 1:10 for other commodities when the new requirements come into force (presumably in the second half of 2018). The leverage for trading CFDs on crypto currencies has even been limited to 1:2.
This restriction on the leverage available to Retail Clients resulted in a significant increase in margin requirements for the instruments concerned. Professional Clients are exempt from this restriction.
What does Margin Level mean?
In order to better understand all areas of foreign exchange trading, you should also know all the details about margin. To do this, we first want to familiarize you with a term that you should definitely understand: The Margin Level. The Forex Margin Level is the percentage of your equity in the margin used. In other words, it is the ratio of equity to margin and is calculated as follows:
Margin Level = (equity/used margin) x 100.
Brokers use Margin Levels to determine whether Forex traders can open additional positions or not.
Different brokers will also set different limits for the margin level, but most brokers set this limit at 100 percent. This limit is known as the Margin Call Level. Technically, the margin call level means that once your account has reached the margin level of 100 percent, you can close your positions, but not open any more. This means that you will reach the 100 percent margin call level if the total equity is only equal to the deposit amount. This event usually takes place if you are in the loss zone with positions and the market continues to run fast and steadily against you. If your equity is only equal to the margin sum, you will no longer be able to take new positions.
What does the Margin Level in Forex & CFD trading mean? We will explain this in more detail using an example to answer this question. Imagine you have an account with equity of $10,000 and you have a position in the loss zone with a margin of $1,000. Now, if your position goes against your expectations, it can lead to a loss of up to $9,000. In this case, your equity would then be only $1,000 and would correspond to the amount of the deposit of $1,000. Thus, the margin level is 100 percent. Please note this again: If the margin level is 100 percent, you cannot open any more positions, unless the market suddenly turns in your favor and your equity is again above the deposited margin.
Let’s assume that the market continues to run against you. In this case, your broker will have no choice but to close all your loss positions. This special procedure is known as the Stop Out Level. For example, if a broker’s Stop Out level is 50%, the trading platform will automatically start closing your loss positions when the 50% margin level is reached. It should be noted that the trading platform first liquidates the largest loss positions.
Often, closing a loss position leads to an increase in the margin level above fifty percent. This happens because the closed position releases a small part of the margin total. In this way, the total margin required is reduced and consequently the margin level rises. The system often increases the margin level to over fifty percent because it closes the largest loss position first. If further positions increase your losses and reach the margin level of fifty percent again, the trading platform will automatically close the next higher loss position.
You may be wondering why brokers do this. Well, the reason why brokers close positions when the margin level reaches the stop out level is explained quite quickly: Brokers simply cannot allow traders to lose more money than they have deposited into their account. After all, the market could possibly continue to run against you and no broker could afford to bear these sustained losses for you and many other traders in the long run.
What does free margin mean in Forex & CFD trading?
The free margin is the sum of your equity that is not tied up in any position and that you can use for new positions in the market. But that’s not all, because the free margin is also the difference between your equity and your margin already deposited. If your open positions are in a profitable range and continue to rise, they contribute even more to your equity and in this way the free margin also increases.
In this context, another point should be addressed. There are trading situations in which you have several open positions and have created pending orders at the same time. The market now wants to trigger one of your pending orders, but you do not have enough free margin on your trading account. Now this pending order will either not be executed or will be deleted automatically. In such cases, some traders think their broker has failed to execute the order and quickly speak of a bad broker. But in this context this is a false conclusion, because the trader simply did not have enough free margin on his trading account.
What does the Margin Call mean?
The Margin Call is one of the biggest nightmares a Forex trader can experience. This nightmare occurs when your broker informs you that your margin has fallen below the required minimum level because one or more open positions have developed contrary to your expectations. Trading on margin can be a profitable forex strategy, but it is important to understand all possible risks. You should make sure that you understand how a margin account works. You should also know the margin agreement between you and your broker. If you do not understand any part of this agreement and if you have any questions, please feel free to contact our customer support in Berlin.
There is one unfortunate fact you should consider regarding the margin call in Forex & CFD trading because you are unlikely to receive that margin call in the first place. Your positions will have been automatically closed in advance. If your funds in your trading account are below margin requirements, your broker will automatically close some or all of the positions in your account. We have already described this case several times here. Nevertheless, this measure serves not only as a hedge for your broker, but above all as security for yourself, as your trading account is protected from negative balances in this way and you can never lose more than your invested capital through trading with Forex and CFDs.
How can you still avoid this unwelcome surprise? Margin calls can be effectively avoided by regularly and accurately controlling your trading account and using stop loss orders on each position to minimize risk.
Margins are a controversial issue. Some traders argue that too much margin is very dangerous. However, it always depends on the trader and his experience. If you want to trade on margin with a trading account, you should know and understand your broker’s procedures and rules, as well as the risks involved. Be careful and definitely avoid the margin call.
As we approach the end of our guide, it is still important to draw your attention to a fact. Most brokers require a higher margin for positions over the weekend. In fact, the margin could rise from one percent during the trading week to two percent or higher if you want to hold the position over the weekend.
You now understand that margin is an important element of trading Forex and CFDs and should not be underestimated, otherwise you may experience unpleasant results. To avoid high losses and excessive risk, you should understand the theory and operation of margins, margin levels and margin calls and combine them with your trading experience to create a viable forex trading strategy. Ultimately, a thoughtful and well-developed approach will usually lead to profits.