Those who are into forex trading must be well-versed with the term margin as it plays a key role in trading. If you are a newbie taking the first lessons to step into the dynamic currency market as a trader, then you should be able to understand the concept of margin trading as well as free margin in forex. Because margin also plays a key role in the calculations that one has to do before placing a trade. This beginner’s guide can be the right place for you to learn more about the margin and the easiest methods for calculating the margin while making trading decisions.
Meaning of margin trading:
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Margin is actually the minimum amount of funds that you need to have in your forex trading account for placing a trade in the live market. The margin requirement depends on the size of the trade position you plan to open. Your trading account balance should be sufficient to place the order for the trade as well as to cover the costs that come as a part of the trading process. These costs include spreads, commission and swap rates if you open overnight positions.
So, having enough margin in your trading account is essential for an uninterrupted trading process. Your broker won’t allow you to place a specific trade if your trading account doesn’t meet the margin requirement. If the margin shortfall (if your account balance falls below the margin levels during a trade) happens later due to a losing trade, the broker will notify you to add more funds with a margin call. If you fail to do so, the broker will automatically close the trades.
Another inseparable part of margin in forex is the application of leverage. Leverage is the facility with which you can trade with a lower amount of funds as your broker allows you to open bigger positions. So, when you avail leverage from brokers, they allow you to place trades with a lesser margin requirement. The higher the leverage you get, the lesser the margin you need for placing big-size trades. To calculate the leverage, you can use trading tools offered by the brokers, which help you determine the right leverage you should use in the trades.
Basically, the margin in forex is a kind of security that the trader pays for the trades they place through the broker. Now, the margin requirement would be different with different brokers, and they also depend on the currency pair chosen as a trading instrument, the base currency with which you have funded the account, trade size in lots, and leverage availed.
Steps for Margin Calculation
The formula for margin calculation is stated below:
(Number of lots being traded * number of currency units in the lot * exchange rate of currencies) / leverage availed = Margin
Let’s make this clearer with an example. Imagine you have USD as your account base currency, and you will trade with USD/JPY with 200:1 leverage, and the trade size is 1 standard lot, which has 1,00,000 currency units. So, you can calculate this manually as:
(1*1,00,000* real-time exchange rate of USD/JPY) /200
Imagine the real-time exchange rate gives us the result of margin as 500 USD, which means you will need $500 as margin in your account for opening this particular trade with the desired lot size. If your account doesn’t have $500, you can consider lowering the trade size or increasing the leverage. If you consider the same trade scenario with a leverage of 300x, you will see the margin requirement coming down to $333.33. Imagine you go for a higher leverage of 400x; at this time, you can only place the same trade with a balance of $250.
As you can see, when you doubled the leverage from 200x to 400x, the margin requirement was reduced by 50% as well. So, leverage and margin requirements are closely dependent on each other. But different brokers have different terms & conditions for leverage and margin levels, and you need to see what kind of leverage and margin specifications your broker states. In fact, we suggest you choose a broker only after checking the leverage offered and margin requirements, as it greatly impacts your trades.
Now, the calculation of margin may look easy for experienced traders or those with a good amount of knowledge in trade-related calculations. But an average newbie trader may have a hard time grasping the concept of margin to begin with, and doing these calculations manually before every trade will take a lot of time. The chances of errors will also be higher in manual calculation of margin as you need to keep track of real-time exchange rates, too.
In this case, you should use automated tools like forex margin calculators, which come as a part of the trading calculator set provided by brokers and trading platforms. You need to check if your broker offers an automated tool to calculate margin precisely and effortlessly. Typically, such calculators can be used for free when you have an internet connection, and they also give instant results as soon as you enter the relevant information such as trade size, currency pair being traded, base currency of account and leverage used.
How is free margin different from margin?
Now, you have learned the basics of margin in forex, but there is another term called free margin, which is different from margin. Free margin is actually the amount in your trading account in addition to the required margin. In other words, it’s the balance left in your account after meeting the margin requirement for a particular trade. This free margin is available for placing additional trades as well as for withdrawal. This means you won’t be able to withdraw the margin money during a trade, but you can withdraw the free margin, which is not being used for any trade at the moment.
Once you close all of your trade positions, the free margin will equal the total account balance, also referred to as equity. A pro trader will always keep some free margin in their account to stay on the safe side, as not having enough free margin places your account in a dangerous position as you run the risk of a margin shortfall, which can happen anytime if you lose a trade. When the free margin drops to zero or moves closer to zero, some brokers may alert you with a margin call, as a further drop will result in insufficient margin.
The formula for free margin calculation
Calculating free margin is easy once you know the required margin for a trade and your account balance before placing the trade. You just need to deduct the required margin for the trade from the total amount of funds in your trading account.
Free Margin = Total account balance/equity – margin requirement for the trade
So, free margin refers to the free funds that can be withdrawn freely anytime. A free margin is considered a sign of financial health for a trading account. So, you must be trying to keep some free margin while trading on a live account. We can refer to the previous example to understand free margin better. Suppose you have a balance of $1000 in your account while the margin requirement is $500. So, the rest of the funds, $500, will be your free margin here. Also, any profits generated from your trades will be added to the free margin.
What is the Margin level?
The margin level is actually a ratio of total equity or account funds to the margin. This will be stated as a percentage and indicates the account’s trade load. The margin levels should always be greater than 100%, as that would mean a lot of free margin is available in your account. When the margin level falls to 100%, the funds are at the same level as the margin, which means you don’t have enough free margin.
You have already placed the maximum amount of trades or maximum trade size with the available funds, and you run the risk of the account being blown up if you end up losing the trades. You can expect to get a margin call anytime in such a situation, making the margin level 100% risky for a trader.
Final words
With that, we are wrapping this beginner’s guide to forex trading margin, as we have described margin and margin calculations in a very comprehensive manner. The best method to avoid a margin shortfall or margin call is to keep your margin levels in check and ensure you utilise the free practice account or demo account facility offered by your broker to learn more about leveraged trading and margin in a risk-free zone. This allows you to prepare better for the live trading session.