What is Margin Trading: Buying on Margin for Beginners
2021-02-18
2021-02-18
What is Margin Trading and is it a good idea for you?Artem Shashkov
Today we will look at the concept of margin in trading.
On the one hand, the word “margin” often goes hand in hand with the words “lending” or “cash loan”, which have a tendency to make traders uneasy. On the other hand, it’s also associated with getting rich fast and other pleasant but unlikely occurrences.
This article is a comprehensive study of the aspects of margin trading, its advantages and disadvantages. I hope this will allow traders to make a more informed decision about the use of this tool.
The article covers the following subjects:
What is Margin?
The main goal in both trading and investing is to make a profit. However, transactions on global exchanges can also be carried out for other purposes, for example as sophisticated strategies to protect business and capital through hedging. It would not be entirely correct to call the ultimate goal of all the financial operations profit. In the financial world, cash is called margin.
Depending on the purpose, margin can be variable, free, hedged, or locked (there are other types). All these derivatives essentially denote an amount of money. If I had to answer the question of what margin is on forex in simple words, I would say that margin is the difference between the opening price of the trade and the current price. The margin on the exchange is no different from the margin on Forex - exchange instruments fluctuate in the same way.
In the example in the screenshot, [EURUSD][1] is bought at a price of 1.20000. When the price of the asset falls to 1.19000, the margin becomes negative because the current price is 0.01 lower than the purchase price. With an increase to 1.22000, the margin on the trade will be positive, since the current price will be 0.02 higher than the buy price.
Margin trading. Margin loan basics explained
In the early 1990s, some brokers saw the potential to expand their client base by attracting traders with small deposits. The advantage of the potential “retail” traders market was permanently high demand - many wanted to try their hand at the stock exchange, but the entry requirements for investors were too demanding.
However, thanks to the introduction of margin trading and the subsequent development of online trading, we now have the opportunity to develop as traders and master one of the most exciting professions of our time step by step.
Apart from the main definition of Forex margin, a trader must understand what margin trading is. Leverage trading is a more popular name for it.
Trade on margin is a way to multiply the funds involved in a transaction at the expense of your broker’s funds. In other words, this is a short- term lending service provided by your broker while you are in the position.
When trading on margin, a trader can use not only their own money, but also the borrowed funds provided by the broker in order to increase the volume of their positions.
The larger the traded volume, the more significant the financial result you can get. The ratio of the trader’s own funds and the broker’s borrowed funds is called leverage.
The advantages for the trader are understandable, but isn’t the broker taking too much risk by providing their funds so trustingly? Don’t worry - the broker has taken care of itself.
In margin trading, margin is a sort of collateral. This is the amount on the client’s trading account required to cover the obligations under the transaction on a particular trading instrument.
The broker provides the trader with funds specifically for a particular transaction. Therefore, the trader must provide the broker with a guarantee that they have enough funds to cover the potential loss.
If the amount of margin is insufficient, the broker will not let you open a trade with the desired parameters. In this case, you will have to either reduce the leverage or reduce the volume of the trade until the amount of required margin becomes less than or equal to the amount available on your account.
Above we have looked at the case with margin lending, in which the higher the leverage used, the higher the margin requirements.
In addition to the leverage of the trade, there is the leverage of the trading account, which, on the contrary, can serve as a method of reducing margin requirements.
According to the rules of exchange trading, trades must be secured. It is necessary to have sufficient funds on your trading account to operate a standard exchange volume of 1 lot. Leverage of your trading account provides you with the ability to trade with deposits that are much smaller than generally accepted exchange standards.
Let me tell you a secret: there is no volume less than 1 lot. It seems impossible, doesn’t it? After all, everyone is used to fractional lots like 0.1 lot or 0.01 lot provided by brokers.
Fractional lots is what margin trading is all about. If brokers did not provide leverage, only traders with large deposits would be able to trade on the exchange.
The above figure demonstrates how the size of your financial leverage affects the margin requirements. The figure displays the minimum margin for trading currency pairs with a standard fixed trading volume of 1 lot.
As you know, a [standard trading lot][2] is the equivalent of 100,000 units of the base currency in a forex trade. Therefore, your margin will be 100,000 when you make a transaction of 1 lot without using the leverage. A position without leverage is written as 1:1.
Next, you see that as soon as the leverage used on the trading account is increased, the margin is reduced by the same ratio. If you increase the leverage by 10 times, and it is 1:10, the margin required will be reduced by 10 times and will be 10,000 currency units. With the maximum possible leverage, a trades will need as little margin as 100 units currency units to ensure a transaction of 1 lot.
Financial leverage and margin risks
Now let’s look at the issue of account leverage in more detail.
Why know its size if this parameter does not seem to be used anywhere? If you approach trading with the utmost seriousness, and not from the position of a beginner, you must have a good idea of all the tools that you use.
There are two types of trader’s behavior when trading on Forex: aggressive and conservative. It depends on the level of risk that the trader is willing to take in their trade. This is directly related to the amount of leverage that the trader uses.
Aggressive trading always involves high risks, which gives a high profit potential. For example, if you want to earn 10,000 USD per week with 100 USD on your account, you will have to trade aggressively. More precisely, go all-in.
For an aggressive trading strategy, the leverage ranges from 1:11 to 1:1,000.
However, if the goal is not to “get rich fast”, the choice falls on conservative trading strategies. The typical leverage will be roughly 1:1 to 1:10.
Consider an example where we can identify an aggressive or conservative strategy.
Suppose a trade was opened in the [EURUSD][1] currency pair at the rate of 1.13120 with a volume of 0.75 lots and a deposit of 2,000 USD. You need to find out what leverage these parameters correspond to. You can do this using the formula:
If we substitute all the values in the formula, we get:
Leverage = (1.13120 * 75,000) / 2000 = 42.42 or 1:42.
This leverage falls within the range of an aggressive trading strategy - the trader works with increased risk.
The trade can be changed into a more conservative form in three ways:
- reduce the quote by searching for another currency pair with a different current rate;
- reduce the volume;
- increase the deposit.
The simplest and most efficient way is to reduce the volume. Let’s now calculate the leverage for the same trade, but with a volume of 0.15 lots.
Leverage = (1.13120 * 15,000) / 2000 = 8.48 or 1: 8.
This leverage is consistent with the conservative strategy.
The concept of leverage is discussed in a lot of detail in the article “[What is Leverage: a Complete Guide for Beginners][3].” I recommend adding it to your bookmarks if you’re a beginner mastering the basics of margin trading.
Buying on margin and powerful examples
Buy on margin is a transaction to buy a financial instrument using leverage. The term “buy on margin” came from stock trading, where investors often trade exclusively with their own funds. On Forex, most retail traders work with leverage, so any buy or sell trade implies margin a priori.
Consider buying on margin in stock trading and Forex trading:
So, using only $5,000 of their own funds, a trader will be able to buy 50 shares if the buy price is $100 per share.
When buying on margin, i.e. using an additional $5,000 of borrowed funds, the trader’s final portfolio will be 100 shares with the same share price.
Therefore, if a trader uses margin, their financial result will be double compared to trading only with their own funds. This applies to both the positive and negative result.
Currency price fluctuations are less significant than those of stock instruments. Therefore, without a margin Forex is inaccessible for retail traders, and leverage values like 1:100 on Forex are average and reasonable. Since such leverage is easy to obtain, you should not use more than 5% of the total deposit amount per trade.
The difference between the results of margin and non-margin trades on Forex is more significant. The stock exchange does not provide chances for either large losses or large profits.
What is a margin position?
A margin position is a leveraged position. Opening a margin position implies trading using additional funds provided by the broker.
If you are a Forex trader, you must be familiar with margin trading. If you trade on the foreign exchange market with your own funds exclusively, you need a substantial deposit to make a significant profit.
Advantages of margin trading
One benefit is the opportunity to increase the potential for profit and grow the initial investment rather quickly. This is especially true when trading currencies. The average daily fluctuations of currency pairs do not allow traders to earn significant amounts of money with small investments.
In the context of Forex, the absence of margin trading would make the foreign exchange market inaccessible to traders with deposits less than 100,000 units, which is the minimum allowable transaction volume. When using leverage for trading, a deposit of $10- $100 is enough.
Margin trading also forces the trader to calculate the risks, since negligence in using large leverage will quickly lead to disastrous consequences. Therefore it makes the trader develop useful skills that they would not have in non-margin trading due to lower risks.
Are there downsides to margin trading?
In unskilled hands the main advantage of margin trading turns into its main disadvantage – I’m talking about the possibility of a large return on the invested capital. A trader can risk too much of their capital and suffer losses quickly.
At the initial stage, traders can be blinded by the prospect of quickly multiplying their total profits by increasing the volume of trades. This blindness prevents them from being impartial and objective and forces them to only believe in the positive outcome of their forecast.
The second drawback is the presence of so-called price gaps and their impact on the deposit. Forex does not work on weekends, but the situation in the world continues to change during the weekend. However, these changes are reflected in the quotes only on Monday. So the opening price on Monday can be strikingly different from the price when the market closed on Friday. If a trader left a leveraged position open over the weekend, on Monday they may face an unpleasant surprise - the price may have changed sharply against the position. In this case, even protective stop orders will not help. A trader who does not follow risk management can lose their entire deposit.
In my opinion, margin trading has another drawback - it is accessible to all traders, regardless of their experience. Beginners seldom educate themselves enough before starting trading. Also, the impact of emotions on their trading decisions is too great. As a result, with the opportunity to earn a lot, a novice trader may not be able to use this tool responsibly.
Minimizing risks with margin trading
When it comes to minimizing risks, it all has long been described in the smallest detail. The problem is that no one listens to these recommendations until they have a negative experience after neglecting them.
If you are one of those traders, let’s once again discuss how to turn margin trading from a dangerous instrument into a useful one:
Regardless of the margin used, in Forex trading the recommended risk is no more than 5% of the deposit per trade. 5% is the absolute maximum value. In other words, the normal risk per trade should be around 1-2%. If you have 12-15 losing trades in a row, this rule will save your deposit.
Do not trade 15 minutes before and 15 minutes after important news releases. An increase in the spread is possible and, as a result, even closing by stop loss will be executed at a much worse price than the trader intended.
If you are trading intraday, don’t leave open positions for the weekend. Price gaps are possible against the direction of your position
Do not invest all your savings in Forex in the hope of quickly doubling them. It’s like lifting the heaviest dumbbell on your first visit to the gym. First get profit on demo, then get a small live account to test your ability to comply with your own trading rules in the face of risk of capital loss. And only then gradually increase the deposit.
When trading on a real account, you need to determine in advance the limit of unprofitable trades for the day, week and month and strictly observe it. All professional traders I spoke with have such a limit. This is a guarantee of the safety of the deposit and minimization of the harmful influence of emotions on your capital.
To summarize, margin can be a useful tool for a forex trader only if a number of strict rules are followed. Otherwise it will aggravate the consequences of all the trader’s shortcomings, instantly reflecting this on the deposit.
What is a margin account
A margin account is an account with a broker where a trader deposits their funds for later use in margin trading. Funds on a margin trading account serve as collateral when opening margin trades. This is in contrast to a standard brokerage account, where only own funds are used in trading. The trade volume available to the trader is determined based on the amount of capital on the margin account and the leverage size.
Initial Margin & Maintenance margin
Initial margin is the amount of funds required to open a trade. If the trader’s equity is lower than initial margin, the requirement is not met, which means that they will not be able to open a new trade.
For example, a trader wants to buy 10 shares for $20. With a 1 to 2 leverage, the initial margin to open this position must be $20x10 / 2 = $100. This amount is frozen on the account until the position is closed.
Maintenance margin is the amount of equity required to keep a trade open. If the trader’s equity is below the maintenance margin, depending on the situation, a margin call or forced closing will follow.
Let’s take the same example and assume that the maintenance margin is 40% of the total, i.e. $200 x 0.4 = $80. Further, suppose that the stock price has dropped from $20 to $12, and the portfolio value is now $120. With ½ leverage, the trader’s equity is now $120⁄2 = $60, which is $20 less than the minimum maintenance level.
Therefore, in this case, a margin call will be enforced and the broker will offer the trader either to deposit additional funds or close the position.
As we see, after entering the market, a trader needs to MAINTAIN a certain equity to keep their positions from being automatically closed.
Margin requirements
In my first trading session on Forex, I opened a lot of trades and was surprised that I couldn’t open even more. The balance of my demo account was saved by the margin requirements - I didn’t have enough equity to open new positions.
Margin requirements are the amount required as collateral to open new trades. With margin requirements the broker reduces the risk of a loss in case of sharp price movements against the trader’s position. As we remember, in margin trade the broker provides the trader with funds to make trades.
Consider an example from the web terminal
You can see the size of the margin requirements for a trade on the selected instrument with the selected volume before opening a trade - it is indicated under the lot size.
After opening a position, the trader sees the following parameters:
The first is the entire amount of margin requirements for already opened trades.
The second is the free margin amount. This is equity minus the margin requirements for open trades. These funds are available for opening new trades.
If before opening the parameter “Available for operations” is lower than the margin requirements for a trade with a certain volume in the selected instrument, then you can continue trading either after changing the instrument, after reducing the trade volume, or after depositing more funds.
Margin rates
Margin rate is a fee for using money or other assets borrowed from a broker.
What assets? For example, when opening a short position on the exchange, the trader first borrows the required number of shares from the broker. The trader must pay for this leveraged operation according to the rates of the stock broker. There is also a fee for using the broker’s money for margin trading.
Margin rate is lower than the interest rates of such instruments as a loan or credit card. Therefore, traders usually prefer to pay for additional funds to a broker than to a bank.
The margin rate is calculated in % per annum. Then it is adjusted based on the duration of use of the borrowed funds.
For example, a trader wants to buy $11,000 worth of stock at 1⁄10 leverage at a 6% margin rate and plans to hold the position for 10 days.
Their equity is $1000. The remaining $10,000 are provided by the broker.
Thus, the trader would pay the following amount for using the broker’s funds for the entire year:
$10,000 x 6% = $600
Therefore, the margin rate trading per 1 day is:
$600⁄365 = $1.64
If a trader plans to hold a position for 10 days, then in fact they will pay for using the margin:
$1.64 x 10 = $16.4
Considering the trader’s potential to make 100x profit with margin funds, this is a pretty good deal.
When trading on Forex, leverage is usually provided to traders for free. This is one of the advantages of Forex trading, especially for beginners.
Crypto margin trading
Let’s take a look at how cryptocurrency margin trading works. In fact, the situation is no different from margin trading with any other instrument.
Given the current cost of 1 bitcoin, most retail traders would hardly use only their own funds to trade this instrument.
The second argument against trading cryptocurrency instruments without margin is their volatility. Average daily price movement of $1500- $3500 for Bitcoin is quite standard.
Thus, in a day you can lose about 10% of the total deposit if you trade exclusively with your own funds.
In my opinion, it makes sense to use margin when trading cryptocurrencies to minimize the trade volume, in contrast to conventional currencies, where leverage is best used as an opportunity to increase the lot size.
To open a trade in Bitcoin with a volume of 0.01 and a leverage of 1⁄100, a trader in the current market conditions will need about $23 of their own funds. Yes, this is more than in currency pairs. But still, it is more affordable than about $22,000 of own funds if you do not use margin trading.
If you want to trade other cryptocurrencies, whose value in most cases is much lower than bitcoin, you should still account for volatility.
This is the [ETHUSD][1] chart, D1 timeframe
The average daily movement is about $50, which roughly corresponds to 10% of the value of the instrument, as is the case with Bitcoin.
To summarize, when trading cryptocurrencies, use margin to make them similar to ordinary currency pairs. This way you can choose the trade volume based exclusively on your risk management rules.
Due to higher volatility, the profit potential of cryptocurrencies is greater than that of currency pairs. Therefore, the second important rule is placing stop loss orders according to the rules of your trading strategy. Without the second rule, despite the large profits, the financial result of the trader might fluctuate near the zero mark due to comparable losses from volatility.
How to track margin in trading
Most trading terminals have the same basic parameters to display the margin value.
Balance. This field displays how much money you have on your trading account, including only complete or exited trades. Current open positions are not included in the Balance field.
Equity. This field displays how much money you actually have on your account, that is including both open and closed positions. Differently put, Equity = Balance – Current profit/loss.
Margin. This field displays how much of your funds are used as collateral or maintenance for the positions open.
Free margin. This field shows how much of your deposit was not involved in the current position and can be used for opening new ones or can be written off from the account.
Margin level. This field displays the relation between your funds and the margin (expressed as a percentage). The margin level shows the current risks.
How do you calculate margin in Forex?
There are two basic ways of calculation margin in forex: simple and very simple.
1. Simple method of how to calculate margin
It will suit those who are good at math. You need to know the price of the currency pair on which you want to open a position, the lot, and the leverage of your trading account.
Margin = (Price* Lot) / account leverage.
We enter our values in this formula to calculate the margin:
Margin = (1.25373 * 10 000) / 400 = 31.34 USD
Thus, we get the amount of the margin required for a transaction with our parameters.
2. Very simple method to calculate margin by margin calculator
It suits everybody, especially those, who don’t like calculating themselves. You will need [forex margin calculator][4].
It is very easy to use the forex margin calculator.
You enter the parameters of your trade: first, you choose the account leverage, currency pair, trade volume, trade type, opening price. The calculator instantly calculates all the parameters of the trade, including the margin size.
Margin level and free margin
I have already explained what margin level in forex is. It is the relation between a trader’s funds and the margin (expressed as a percentage). Margin level is associated with such important concepts as Margin Call and Stop Out. Margin Call occurs when the level of your free funds becomes negative or equal to zero. In this case, you can’t open a new position anymore as all the money on your account is a collateral for the open position. After there has been a Margin Call, there could be a Stop Out. In Forex trading, a Stop Out Level is when your Margin Level falls to a specific percentage (%) level in which your open positions are closed automatically (“liquidated”) by your broker starting from the most losing one to prevent the client from going into the red.
Traders, who apply aggressive strategies, are quite familiar with these situations as they often occur in their trading. Of course, there is nothing pleasant in it, and such situations often result in the loss of the deposit. Traders, employing conservative strategies, may never come across such situations.
Let us see how you can find out Margin Level and how you can calculate Free Margin level.
Free Margin is the difference between Equity and Used Margin.
Free Margin = Equity - Margin = 419 856.12 - 31.34 = 419 824.78
The Margin Level is the percentage (%) value based on the Equity/Used Margin ratio.
Margin Level = (Equity/Margin)* 100% = (419 856.12 / 31.34) * 100% = 1339542.39%
Conclusion
If you apply margin trading correctly, you can considerably increase the performance of your Forex trading strategy. However, this doesn’t mean that you need to use the maximum available financial leverage and expect a miracle.
Reasonable application means that you should select the leverage size comfortable for you, so that you wouldn’t feel huge emotional stress because of the trading process.
There can’t be recommendations on the leverage suitable for all investors, but you must always remember one thing! The less nervous or excited you are, the wiser trading decisions you will take and so, your chances to make a profit increase.
You should always bear in mind that the higher is the financial leverage, the higher is the risk! If you are a beginner trader, you should be more focused on not losing your deposit than on making a huge profits. When you learn to preserve, you will start gaining.
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Ask me questions and comment below. I’ll be glad to answer your questions and give necessary explanations.
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Price chart of EURUSD in real time mode
The content of this article reflects the author’s opinion and does not necessarily reflect the official position of LiteForex. The material published on this page is provided for informational purposes only and should not be considered as the provision of investment advice for the purposes of Directive 2004/39/EC.
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- my.liteforex.com/trading/chart?symbol=EURUSD
- www.liteforex.com/blog/for-beginners/how-to-calculate-a-lot-on-forex/
- www.liteforex.com/blog/for-beginners/forex-leverage/
- www.liteforex.com/trading/forex-calculator/
- my.liteforex.com/?category=for-beginners&slug=margin-trading&openPopup=%2Fregistration%2Fpopup&utm_source=blog&utm_medium=article&utm_campaign=bonus
- my.liteforex.com/deposit/?category=for-beginners&slug=margin-trading&promo_code=BLOG&utm_source=blog&utm_medium=article&utm_campaign=bonus