Understanding margin when trading Forex is a prerequisite to smart trading. In this post, I will explain the essentials of what you need to know about Forex trading margin.
What is margin?
Margin is quite simply collateral issued from your trading account to hold open a trade. Let’s say you want to buy one lot of CHF in the USD/CHF pair. If the USD/CHF pair is trading at 1:1.3836, this means that you will be selling $100,000 USD to buy 138,360 CHF. Fortunately, the broker only requires you to post 1% as collateral. The broker will loan you the rest of that $100,000. In this case, your margin is $1,000 (1% of $100,000). The brokerage loans you $99,000. This $1,000 is now considered used margin. The amount in your account that is not earmarked as margin for the trade is called usable margin. Let’s look at an example using the numbers above.
– You have $1500 in your trading account.
– You buy one lot of USD/CHF.
– Your used margin for this one lot is $1,000.
– This leaves $500 of usable margin.
Using margin can equal too much leverage
So far, in the example above, things might seem fine. In reality, the above scenario is extremely risky. I’ll explain why. Since your broker has only required 1% margin, this means that you are leveraging your money at a ratio of 100:1. This will magnify your profits or losses. Every pip (a change of a hundredth of a cent in the currency) that you lose in the trade will cost you $7.23 USD. When you start losing pips, this loss comes out of your usable margin. Consider this sad scenario as we continue from our previous example.
– The market moves against your position 69 pips. This is a mere 7/10ths of a cent for the currency but equals $498.87 in losses for you.
– Since losses from an open position come out of your usable margin of $500, you now no longer have a single dollar of usable margin.
– Your used margin is still $1,000.
– Your usable margin is now $0.13.
– You can no longer absorb any more losses while still maintaining that 1% margin required to hold open your position.
Here is where a margin call happens
In trading, a margin call is when your broker lets you know that you need to put more money in your account quickly. In the Forex world, a margin call usually means that the broker’s software simply closes your position since you are no longer able to absorb any more losses. You take the loss and you now do not have enough money to open another position.
How to be the master of margin
Since you now understand what you need to know about Forex trading margin, avoiding a margin call is pretty simple.
– Only use the margin/ leverage that fits your risk appetite. This can be done by changing the leverage with your broker or by simply buying fractions of lots instead of whole lots.
– Use stop loss lines so as to limit the risk of a margin call. Know when to admit that the trade is dead.