The term “equity” in the context of forex trading refers to the actual value of a trader’s account. It is not a single factor but a composite of various parameters computed to determine one’s financial position in the forex market.
The critical components of forex equity include margin, leverage, and balance. The three factors are closely interrelated, with fluctuations in one affecting the other. Ultimately, this affects the ability of a trader to transact a trade.
Understanding how leverage, balance, and margin affect trade and how they interrelate is the first step to avoiding margin calls. Whenever you make a loss or a profit, your equity is directly impacted, and this continues for as long as you are actively trading.
Your open positions will not be included in computing your equity. However, once the open positions are closed, the resulting profits or losses will be incorporated. The profits will be added to your equity, while losses will be deducted. Therefore, it will fluctuate as a result.
You should ensure that you incorporate the effects of margin, leverage, balance, and equity on your ability to trade. The best way to achieve this is by ensuring that you open positions to maintain a good balance among the three factors.
The relationship between these factors is discussed below.
Equity and balance
As described above, Equity is the trader’s financial position based on the amount of capital left in their account. If the trader has open positions, their equity is left after deducting the subsequent losses or profits.
A trade is said to be in an open position when there is a pending transaction. Applying this logic, if the trader had opened trade with 1,000 and made a profit of 500, they will have an account balance of 1,000, but the equity will be 1,500.
If the trade results in a 500 loss, the account balance will remain 1,000, but the equity will go downwards to 500. If they have zero open positions, then the resultant equity is equal to the balance.
Leverage
Leverage is a form of loan lent to brokers to enable forex traders to open trades with capital larger than what they have in their trading accounts. It is expressed in the form of ratios. For instance, leverage of 500:1 allows traders to open a trade worth $500 for every $1 they have in their account.
Therefore, if they wanted to open a standard lot of $100,000, the leverage would enable them only to put $200 into the trade.
Leverage can understandably be enticing, considering the kind of boost it gives traders. However, a large trading capital does not increase the chances of a profit but can potentially magnify losses. Therefore, it is advisable to stay away from leverage whenever you can, especially if you are inexperienced.
Margin
Margin is the amount of money in a trader’s brokerage account that a broker requires to keep a trade open. Margin is a derivative of leverage since it is a percentage of the size of the position opened. In an instance where a broker quotes their margin as 1%, they are offering a leverage of 100:1. The workings of equity can be seen clearly from the MT4 window.
Margin fluctuates in response to the profit-making or loss-making experienced in the market by a trader.
However, if the market conditions change and the trader reduces their losses, the trader’s equity will end up going beyond the margin.
The difference between the margin and equity will ultimately determine the size of the next trade. At some point, the trader may not be out of the woods yet as long as the position remains open. If the market conditions go against a trader, resulting in large losses, it may reach a point whereby the trader may not be in a position to support a position.
Take a situation where a trader only has 5000 in their brokerage account. However, the market may become unfavorable over time, leading to 4,500 worth of losses. If the trader had leveraged their position using 1,000, it would mean that their account balance cannot provide the margin needed to keep the trade open.
At this point, the broker would have to make a phone call to the trader, asking them to top up their account. This is known as a margin call. Margin calls are avoidable and may result in situations such as when a trader leaves their position open for too long without a stop loss or failure to take profit in good time before a market reversal.
In summary
Equity is a description of the financial position of a trader’s brokerage account. It is based on the money in their trading account and the outcome of their open positions. It is essential to understand how balance, margin, and leverage affect equity to trade effectively.