What is Margin?
| Trading more for less… |
We first need to understand the term, margin finance, to understand how margin trading work. Margin finance is essential money which you borrow from your brokerage firm to purchase an investment. Margin will therefore be referring to the level of investor equity in the account.
Margin trading allows traders to access greater sums of capital, allowing them to leverage their positions. Essentially, margin trading amplifies trading results so that traders are able to realize larger profits on successful trades. However, amplifying of results goes both way, which means losses are also amplified if the trade goes against the traders. This ability to expand trading results makes margin trading especially popular in low-volatility markets, particularly the international Forex market.
Most Forex brokerage firm provide margin accounts. For our list of broker comparison please click here.
How does margin trading work?
When a margin trade is initiated, the trader will be required to commit a percentage of the total order value. This initial investment is known as the initial margin, and it is closely related to the concept of leverage. In other words, margin trading accounts are used to create leveraged trading, and the leverage describes the ratio of borrowed funds to the margin. For example, to open a $100,000 trade at a leverage of 50:1(i.e 2% margin), a trader would need to commit $2,000 of their capital.
Margin trading can be used to open both long and short positions. A long position reflects an assumption that the price of the asset will go up, while a short position reflects the opposite. While the margin position is open, the trader’s assets act as collateral for the borrowed funds. This is critical for traders to understand, as most brokerages reserve the right to force the sale of these assets in case the market moves against their position (above or below a certain threshold).
For instance, if a trader opens a long leveraged position, they could be margin called when the price drops significantly. A margin call occurs when a trader is required to deposit more funds into their margin account in order to maintain the minimum margin trading requirements. If the trader fails to do so, their holdings are automatically liquidated to cover their losses. Typically, this occurs when the total value of the equities in a margin account, also known as the Maintenance margin, drops below the margin requirements of that exchange or broker.
Calculating Margin
Certain brokers calculate margin requirements differently depending on whether you used a stop-loss for your trades. For example, IG have three ways of calculating margins depending if you open a position with 1) no stop-loss, 2) stop-loss or 3) guaranteed stop-loss. The use of stop-loss by traders will allow brokers to estimate the maximum loss from a position and better facilitate margin requirements.
The following is an example of how IG calculates its margin requirement. (click on the image for more info)
In Short
Margin trading are common for Forex trading. It can be an effective way for traders to maximize their profit. However, without good risk management technical many traders may end up losing more than they invested. Alternatively, traders can utilize stop-loss to protect themselves and broker such as IG encourages these by setting lower margin requirements as compare to a position without stop-loss.
