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Complete Forex Trading Guide for Beginners

8.How Margin Trading Works

Retail traders are increasingly attracted to the Forex market, because investing in currency pairs has become increasingly accessible and can be traded 24 hours a day.

However, some trading concepts are still unclear to many investors who wish to succeed in currency trading.

For example, even though a margin account may be opened, many traders aren’t be able to provide a clear definition of margin trading, or leverage.

Yet both concepts are essential to fully understand how to profitably trade the foreign exchange market. 

Let’s begin …

 

A Word of Caution:

Buying on margin isn’t for every kind of trader.

It is more suitable to short-term trading styles such as scalping, or day trading, as investors need to pay interest rates on their margin loan.

These interests increase over time, and need to be taken into account when calculating profits and losses. The longer a trader keeps a position open with margin trading, the higher the interest rates will be.

 

What is margin trading?

Leverage and Required Margins

Leverage and Required Margins

Unlike cash accounts, margin accounts allow you to use borrowed money to open and hold it.

Margin trading allows you to take advantage of fuller exposure to the financial markets, while only using a portion of the trading capital you would normally need to invest.

This means that you can invest more money than you currently own in your brokerage account.

For each position you want to open, there is a margin requirement associated, which is the amount of money you need to put aside, as a collateral, or security deposit.

 

Did you know?

Margins are usually expressed as a percentage of the total amount of your trading position. For example, Forex brokers may require a 2%, 1%, or .5% margin.

 

Watch: All About Forex Trading using Margin:

 

Leverage is a by-product of margin

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Leverage allows a trader to control larger trading positions than what they could with their own trading capital.

If not used properly, leverage can be a dangerous tool, as it can magnify losses as well as profits.

 

Leverage and margin are linked as shown by the following example:

 

Different margin requirements

If your broker has a margin requirement of:

  • 5%, then your leverage will be 20:1
  • 3%, then your leverage will be 33:1
  • 2%, then your leverage will be 50:1
  • 1%, then your leverage will be 100:1

 

There are other terms you’ll see in your trading platform that you need to know about, such as margin positions, initial margin, maintenance margin, margin calls, and negative balance protection, among others.

 

Initial margin

The initial margin, sometimes called the deposit margin, is the minimum amount that will be required from you to open a trading position.

Because this margin is only a small part of the full value of your position, this amount might not be enough to cover your losses if the market turns against you. You’ll then need to monitor your maintenance margin.

 

Maintenance margin

The maintenance margin is supposed to ensure that you will have enough capital to keep your positions open, as it should cover any running losses. It represents the minimum balance that you should maintain in your account.

 

Margin call

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If your trading position evolves against you, and your current capital cannot cover your potential losses, then you will receive a margin call from your broker.

This occurs when the equity of your account falls below your broker’s regulatory requirements about margin debt.

At that point, your broker may require a deposit of a certain amount of money in your trading account. You can make this with your credit card, or any other method of payment, if you want to keep your positions open.

 

Negative balance protection

Sometimes, stop-loss orders, or margin calls, aren’t enough for traders to avoid excessive losses. This happens when the market isn’t liquid, or when there are very fast-paced, volatile price movements, with gaps and slippage.

 

For example

On January 15th, 2015, the Swiss National Bank (SNB) decided to stop the minimum exchange rate of CHF 1.20 per Euro, and created a flash crash on the Swiss Franc.

That day, the EUR/CHF currency pair dropped as much as 40% in just a few minutes, forcing FXCM’s clients to sustain more than USD 225 million in negative balances.

 

Many brokers offer a negative balance protection, which provides a safeguard to traders in times of higher volatility and trading volume, so they don’t face a negative balance, and go into debt.

 

 

Examples of margin trading

Since August 2018, the European Securities and Markets Authority (ESMA) requires that brokers apply leverage limits on the opening of a CFD position, which is 30:1 for major currency pairs.

Using this leverage means that for every dollar you put up, you’re able to trade $30 of a major currency.

 

For example

Let’s say that you’re able to put aside a $3,000 margin.

This means that you can initially invest a maximum of $90,000 ($3,000 x 30) in trading positions.

Of course, this amount will fluctuate depending on your profits or losses – not to mention commissions, interest and other fees.

 

Another example – if you want to trade a “lot” on the EUR/USD, which equates to $100,000, and your broker is asking for a 1% margin, this means that you only need to deposit $1,000 into your trading account, and the other 99% will be loaned by your broker.

Read more about how ESMA’s new regulations change the trading landscape.

 

Risks of margin trading

Borrowing money to invest in a volatile market is risky, as market values can change rapidly, and there is a possibility that the market moves against you, which will in turn increase your losses.

More than that, markets can move so quickly that it’s possible for you to lose more money than your initial deposit, as your balance can turn negative after margin calls.

You will then owe money to your broker if it doesn’t offer negative balance protection. If you can’t meet the margin call, your losing positions will be closed, forcing you into liquidation.

Keep an eye on your broker’s policies about margin requirements and leverage

Keep an eye on your broker’s policies about margin requirements and leverage, as depending on the currency pairs, or the inherent economical or geopolitical risks, these policies can affect your trading.

Read: The Newbies Guide to Choosing a Broker

Remember: Trading on margin amplifies your profits AND your losses, which means that you need to follow money and risk management rules to avoid wiping out your trading account.

Read: Awesome Risk Management Strategies for Forex That Will Save You Money

 

So, is margin trading good or bad?

Well, margin trading is an incredible opportunity offered by brokerage houses to invest in the financial markets with a small initial investment.

Of course, this isn’t without any risks, but if managed well, you can make large profits while trading currencies. Be sure to keep track of your FX trading positions, and know the fundamentals of the currencies you’re investing in.

 

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