Trading on the margin allows you to deal with your own limited funds as well as some amount borrowed from a broker. Read further to understand what a margin account is, how you can create one, and why it is important for your investments.
What is margin trading?
Forex margin is simply the money you have given your broker for safekeeping. Margin is not the cost of a transaction, rather a security deposit based on the strength of your trading account that you as an investor can keep with your broker to venture into trades larger than what your funds may allow you.
A margin is not a commission or a fee but a part of your trading account balance. It is a trading account that you can invest with an extra dollar for each dollar you have. When you trade forex using margin, you pay merely a percentage of the complete value of the positions which open your trade.
Trading on margin allows you as a trader to open leveraged trading positions – allowing you more exposure than what your limited funds could have given you. Although trading forex on margin amplifies both profits and losses, it is best advised to understand the risks you are getting into before committing.
Forex margin calculator
Almost all brokers now provide the facility of automatic margin calculation. To calculate the forex margin requirement, you will need to enter the trade currency, currency pair, leverage, and trade size. For instance, a broker has a 25:1 margin ratio for EUR/USD, and you want to open 200,000 units when the currency pair is at 1.1719. Considering your account currency is USD, the margin needed to place the trade will be $9,375.2.
How to trade using margin?
Prior to making a trade, you will have to deposit money in your trading account – the amount is determined by the broker’s agreed percentage. Normally, accounts trading in 100,000 currency or more has a margin of 1% or 2%.
You can understand trading on the margin with the following examples.
Case study #1
You will need to deposit $2,000 (1%) as a margin if you want to trade $200,000. Your broker will provide you with 99% of $200,000.
Margin requirements differ from broker to broker. Sometimes when the brokers hold the positions for you during weekends or even overnight, they tend to increase the margin percent to avoid the risk of liquidity.
The $2,000 margin deposited with the broker is used as a security by him. If your position in the market deteriorates and your losses reach near $2,000, the broker can instigate a margin call. In such a case, you will be asked by the broker to either increase the security amount in your account or close the position to diminish the risk to the parties involved.
In some cases, you may lose a substantial amount of trading capital due to the volatility of the market – the broker can liquidate the account and inform you later that your account was subject to a margin call.
Case study #2
In another case, consider your forex account balance between having $20,000, and you place two trades. Your broker’s condition is to deposit $5,000 in order to keep these positions open.
Here, the margin level is [$20,000/$5000]*100 = 400%. It means, the higher the margin, the more trades you can make with additional cash.
In case the margin level drops to 100%, there won’t be any additional margin-left to make the trades.
Why it is Important: key benefits
Margin trading has various benefits that make it attractive to traders. Some of the benefits are:
- Diversification of a centralized portfolio. Suppose your portfolio has a large quantum of currencies (major, minor, or exotic currency pairs). This is like putting too many eggs in one basket. When you create a margin account, you will be able to procure a loan against your current holdings. This way, you can expand your portfolio without selling your stock of original currencies.
- Short-selling. In short selling, an investor makes a profit from declining currency prices. To short sell, you have to borrow the currency from a broker to sell them and keep a margin amount as security. If the market is in your favor, you will sell the currency at a lower price in the future and make a profit from the difference in the amount. You must have a decent quantum as margin in your account if you want to short sell.
- Line of credit. When you procure a margin loan, you are liable to pay some interest. In this case, the rate of interest on margin loans is lower than the bank’s credit card/loan interest rate because they are pegged to the federal funds’ target rate.
- Repayment schedule. As long as your debt does not exceed the set demand in the margin account, you can pay your loan according to your own schedule.
- High returns. Suppose you want to invest in currencies worth $40,000 with $20,000 cash and $20,000 borrowed. As and when the value of the securities increases, say, to about 25%, i.e., $10,000, your equity increases to $30,000 while the borrowed amount stays the same at $10,000. This means that the growth rate of equity is 50%.
- Lesser capital requirement. When investing without leverage, you have to arrange a lot of capital to make profits and survive in the market. You may deposit a small amount of money with your broker as a margin, which will grant you access to a large capital to invest.
Bottom line
While trading forex, the margin is the percentage of your trading account that you have to put forward in order to maintain a position in the market.
It is not a transaction fee but a security deposit. Margin allows a trader to trade for more than what they have in their account. However, a margin is a temporary relaxation and not a free pass – a novice trader can incur massive losses and end up with an empty trading account. A margin call is a trader’s worst nightmare, especially if you have a dearth of funds. It is essential to have comprehensive knowledge about how margin works, as well as how much you can actually afford to stretch your margin, and whether you are capable of margin trading.