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When you first get involved in forex trading, there will be a variety of terms that you could come across. One of these terms is “margin”. Far from being intimidating, the margin is simply the amount of money you must contribute to open a new trade (position).
Forex trading typically involves dealing in large amounts of currency in terms of “lots”. 1 standard USD lot, for example, is $100,000. You do not need to put down the whole amount from your own capital, this is where the margin comes into play. Here we will go into more detail about exactly what the margin is, how margin trading within forex works, and some things you should look out for.
Do Forex Brokers Profit from the Margin?
This is a common misconception among some new forex traders. The margin is not a fee of any sort, and the top forex brokers in the industry do not make any kind of profit from the margin in that respect.
All the margin with any forex broker does is to ensure that a certain amount of your own funds are set aside to help cover the cost of any losses you may make on a position you have opened. This margin is effectively the key to enjoying the leverage in forex that your broker provides.
Analyzing the situation on a deeper level, while the forex broker does not directly profit from the margin, they do indirectly benefit from providing you this opportunity to engage in margin trading. This is something we can take a look at in the following section with the provision of some simple to follow examples.
How a Broker Benefits from the Margin
Although not directly profiting from the margin, brokers are able to derive some indirect benefits. The first of these is that simply put, the margin makes it easier for you as a trader to get involved in the forex market. While there are still risks involved of course, the more a broker can encourage you to trade by making it as easy as possible, the more you are likely to engage.
The second key reason that sees brokers garner indirect benefit from the margin is the fact that when you are trading more, and with larger amounts, they can gain additional commissions and perhaps profit from markups on the forex spread and that of other markets beyond forex too which they likely provide trading in.
In summary then, the main benefit for a broker when it comes to the margin in forex is that you will trade more in terms of both frequency and volume.
Understanding Margin Levels
As mentioned, the margin is the amount of your available funds that will be held against your open trades. As you open more positions, this amount continues to increase. These funds that are then essentially locked-in by the broker to secure your position are known as your used margin, while the funds still available can be referred to as available margin, or available equity.
We can then use both of these numbers together in the following formula to calculate your current margin level:
Equity/Used Margin x 100 = Margin Level.
As a forex trader, it becomes very important to know this number id you are engaging in margin trading. This is since most top forex brokers will require your margin level to be at least 100% or more in order to avoid a margin call situation. Therefore, you should ensure to keep an eye on this as you are opening new positions.
If you deposit $1,000 in a forex trading account and continue to open 1 position, a typical broker may require $50 in margin (This can be as low as $33 with CySEC regulated brokers, and even as low as $2 with some others). Following the calculation above:
Equity ($1,000)/Used Margin ($50) x 100 = 2000% (Margin Level)
In this case, then you are still well within a healthy margin level, open just a few more small trades though, and this number can change quickly.
What is a Margin Call?
The first important point to note here is that many top forex brokers have what they often refer to as “negative balance protection”. This means that before you even get to the situation of having a margin call, your positions may be automatically closed by the broker.
A margin call happens when your margin level drops below 100%. What this essentially means is that you no longer have enough funds in your account to cover the margin requirements on your open positions.
In this case, you will typically be presented with a couple of options, you could close some of your open positions, or you could deposit more funds to your account. In either case, this is probably a situation that you would prefer to avoid through careful risk management.
Pros and Cons of Margin Trading
Margin trading can open great possibilities for you as a forex trader to engage in markets to a much higher level than you could with just your own funds. It also means that you can work well to diversify your portfolio with a number of investments in various markets. Beyond this, margin trading means you can always be in a position to make a move in the forex market if you spot an opportunity.
It is well worth remembering though, that as the largest trading market in the world by volume, the forex market can move incredibly fast. Measured in pips, these movements may seem small, and insignificant. If you are engaged in margin trading though, you should remember that your position is very much amplified. This means that even small movements in the asset price, cold mean big changes in your position.
The very best advice you can heed is to take the opportunity that a margin presents, but remain mindful and have a strong risk management strategy in place.
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Anthony is a financial journalist and business advisor with several years’ experience writing for some of the most well-known sites in the Forex world. A keen trader turned industry writer, he is currently based in Shanghai with a finger on the pulse of Asia’s biggest markets.