The forex market offers participants the potential to trade on margin. The ability to trade on margin is one of the attractive – albeit risky – features of forex trading. Trading on margin essentially allows the forex trader to trade on borrowed funds. The degree to which the trader can borrow will depend on the broker they are using and the leverage or gearing they offer.
In the forex market, margin refers to the amount of money required to open a leveraged position or a contract in the market. By offering leverage to the trader, the brokerage is essentially allowing the trader to open a contractual position with considerably less initial capital outlay. For instance, a trader placing a standard-lot trade in the market would need to post the full contract value of $100,000 in order to have his or her trade executed without leverage. With leverage, this trader can place the same $100,000 contract for an amount of margin (determined by the set level of leverage). For example, an account at 1:100 leverage would require $1,000 of margin to place a $100,000 trade.
Trading forex on margin should be used wisely as it magnifies both your potential profits and potential losses. Remember: the higher the leverage, the higher the risk.
Forex traders are subject to the margin rules set by their chosen brokers. In order to protect themselves and their traders, brokers set margin requirements and levels at which traders are subject to margin calls. A margin call would occur when a trader is utilising too much of his or her available margin. Spread across too many losing trades, an over-margined account can give a broker the right to close a trader's open positions. Traders should be clear on the parameters of their own accounts, i.e. at what level they would be subject to a margin call. Be sure to read the margin agreement in the account application when opening a Live Account.
Traders should monitor their margin balance on a regular basis and use stop-loss orders to limit downside risk. However, due to the forex market’s extreme volatility, stop-loss orders are not always effective in limiting downside risk. There is still the possibility of losing all, or more, of your original investment.
Every trader should know what level of risk he or she wishes to take. Whilst the attraction of taking on a big position to receive increased profits is quite clear, it should also be noted that a slight movement in the market will result in a much higher loss in an overly leveraged account.
Traders always have the option of applying a lower level of leverage to an account or transaction. Doing so may help manage risk, but bear in mind that a lower level of leverage will mean that a larger margin deposit will be required for contracts of the same size.
To calculate the margin required to execute 1 mini lot of USD/CAD ($10,000) at 1:100 leverage in a $500 mini account, simply divide the deal size by the leverage amount, e.g. 10,000/100 = 100. Therefore, a $100 margin will be required to place this trade, leaving a $400 marginable balance in the Trading Account.
Most forex trading software platforms automatically calculate the margin requirements and check the trader’s available funds before allowing him or her to enter a new position.
In the above example, we had a $500 account. In order to open the position above we were required to have an initial margin of $100. This is referred to as used margin. The remaining $400 is known as the free margin. All things being equal, the free margin is always available to trade with.
Today’s trading platforms have become very sophisticated as they calculate these figures in real time, eliminating the need to do so manually.
Each standard lot traded in the forex market is a 100,000 (of the base currency) contract. In other words, when trading one lot in a standard account, a trader is essentially placing a $100,000 trade in the market. Without leverage, many investors would not be able to afford such a transaction. Leverage of 1:100 would allow a trader to place the same one-lot ($100,000) trade by posting $1,000 in margin.
Many retail forex brokers also offer the ability to trade mini lots. Mini lots essentially allow the trader to trade one-tenth of a standard lot. Trading in this size is often referred to as trading a mini lot. Mini-lot contracts are $10,000 (of the base currency). A trade of one mini lot would be a $10,000 trade. Trading with 1:100 leverage would mean that $100 of margin would control a $10,000 contract.