What Is Margin Trading?
In the world of forex, margin trading (or “buying on margin”, or “trading on margin”) means trading with short-term borrowed capital. Margin is thus a form of borrowed money or debt. This borrowed capital is used to buy much more currency that you’d be able to purchase ordinarily (unless you have hundreds of thousands of dollars available). In the forex market, currencies are usually traded in lots, with a standard lot being $100,000. (The forex market is a highly leveraged market.) The term “lot” refers to the minimum amount of currency that must be bought. To achieve this amount of currency, brokers offer a margin trading option. This means that through your margin account, you can execute deals with a small amount of initial capital. You can open $100,000 or $10,000 positions with as little as $50 or $1,000. In forex, trading small amounts makes no sense since profits can only be made through large amounts of currency.
Let’s take an example of margin trading:
- Some market indicators are telling you that the Euro will strengthen against the US Dollar.
- You believe it’s the right time to buy EUR/USD and you open a position of $100,000 (one lot) to buy Euros with a 1% margin at the price of 1.3520 hoping that the rate will rise. This means that you are holding $100,000 worth of Euros with an initial deposit of $1,000.
- The price does rise and reaches 1.3570
- You decide to sell and close your position. You have won about $500 (50 pips x $10 per pip), which constitutes a 50% return on your initial capital investment of $1,000.
- You know have $1,500 in your account.
Also, brokers use this forex margin as collateral to cover any losses incurred by the trader. Since in margin trading, nothing is actually sold or bought for delivery, the funds in your account serve as margin requirements. Those margin requirements vary depending on which brokerage firm you choose.
To match its traders’ risk levels, Finotec offers low margin requirements – as low as 0.5%. However, we advise traders new in the forex industry to start trading with higher forex margin capacities to minimize the amount of risk involved in such transactions.
What Is a Margin Call?
As you know, forex is a speculative activity, through which you can either win or lose money. When the market moves against your position, there is a risk that the capital in your account will fall below margin requirements. In this case, the broker will issue a margin call for you to add funds. If you fail to do so, your position(s) will be closed to prevent further losses. A margin call thus prevents you from having a negative balance in your account.
Example :
A trader opens a $10,000 trading account. He then opens one lot of the GBP/USD with a margin requirement of $1,000 (used margin). This means that he now has a $9,000 usable margin. The used margin refers to the capital available for potential losses or for the purchase of new positions.
In the event that the market moves against your position and that your losses exceed the $9,000 of your usable margin, if you do not add funds upon receiving a margin call, your position will be closed. By closing your position, your broker limits both his and your risk. The consequence is that when trading forex online, you will never lose more than what you’ve deposited in your account.
How are Margin and Leverage connected?
In forex trading, you use margin to create leverage. In other words, leverage is the process by which you reinvest the debt (margin) to make bigger profits. Leverage options are expressed either in terms of leverage ratio (for example 200:1) or in terms of margin percentage (for example 0.5%).
Leverage and margin are connected according to this simple relationship:
Margin percentage = 100 / leverage
Leverage = 100 / margin percentage
For example, Finotec offers a 200:1 leverage. What is the corresponding margin percentage? According to the ratio above, the margin percentage is: 100/200 = 0.5%