There are many important theories and fundamental concepts that you need to learn before stepping into the dynamic forex market as a trader. Because you won’t be able to understand the technicalities without grasping the idea behind it. Applying the concepts you studied in real time is a key skill that takes you closer to success in currency trading which is complex and simple at the same time. It is complex when you are a complete beginner trying to gain basic level knowledge and once you crack the code, the trading process will eventually get a lot simpler and less stressful.
One such simple yet complex concept that can make or break your trading career is how you utilise margin and leverage as a trader. Margin surely plays a key role in the trading process and this blog thoroughly explains the same.
Meaning of Margin
The term margin has multiple meanings but in the context of forex trading, it means the amount of money that has to be deposited or maintained in your trading account for opening a trade position. When you are trading with leverage, the margin is collateral that your broker demands to let you open a larger trade with a smaller amount of capital. Hence, fulfilling the margin requirement is essential to keep the trade running. Leverage is like a loan that you take from the broker for trading and margin is the security they need to let you open larger-sized trades.
The margin requirement can be easily calculated by entering the chosen currency pair, trade size and leverage into a margin calculator. It automatically applies the margin formula for finding the margin amount in your base currency with high precision by applying the real-time exchange rate. Such simple online tools can save you time as they provide accurate information right away, allowing you to make sound trading decisions.
Leverage Ratio
The amount of money that has to be there in your account to meet the margin requirement is dependent on two things: your position size and your chosen leverage ratio. Since leverage works like an amplifier for trade size, the leverage ratio states the size of the trade position in proportion to the margin or collateral. If you select 100:1 as the leverage ratio, you just need to have 1% money of the total trade size to open a position. In other words, for every $1 in your account, you can open a trade worth $100.
When you choose a higher leverage ratio, the margin requirement will be lower. Leverage is a very powerful tool that can magnify your profits and losses alike depending on the direction in which the market will move at the end of a trade. If you win the trade with 100:1 leverage, your profits will be amplified but if you lose the trade, your loss will be just as huge. However, this does not stop traders from using leverage as it allows them to control a larger position and maximise the gains without having all the money deposited in their accounts.
The larger the size of a trade gets, the greater will be the profit potential and you can use a forex profit calculator to get a clearer idea about the potential earnings of a trade. You just need to enter the details of the trade into the online calculator and it will show you the profits you can make by winning the trade. You need to enter the instrument being traded, account base currency, lot size and prices at which you will be opening and closing the trade after the win. You need to enter the amplified position size when trading with leverage.
This tool also applies real-time exchange rates for finding the value of your preferred currency. You won’t have to calculate the pip value separately as the online calculator automatically applies the profit formula for providing accurate results real quick. But you should not be choosing the highest leverage ratio solely based on the possible gains of a trade as you may end up losing a bigger amount if your analysis is invalidated later on.
What is a Margin Call?
Just as the name implies, it is a call for margin when your account balance drops below a certain level leading to insufficient margin. The broker will send you a notification about the situation and you will have to deposit additional funds into the account to fix the deficit in the margin. If you don’t take any action in time, the broker will automatically close the open trades. Margin calls are often triggered as a result of a loss in the leveraged trades which has not yet been realised.
Used Margin & Free Margin
Used margin is the money being used to keep a trade open in your account and free margin is the amount of funds that can be freely used for entering a new trade. The free margin can also be withdrawn from your account whereas the used margin is at stake for a trade position that is open. Having enough free margin in your account is like a safety net as you can avoid the risk of a margin call, as you already have some surplus funds in your account to compensate for the potential losses.
Margin, Leverage and Risk Management
How much leverage you use for a trade, how much money is needed to meet the margin requirement and the amount of free margin you keep in your account are all taken into account for measuring the risk that you are taking for a trade. The essence of risk management is to take a calculated risk based on the reward you can expect if the market moves in your favour. Thus, selecting the optimal leverage ratio and having sufficient margin are essential to minimise the risk.
Besides this, you should take some measures to limit the potential losses. This includes trading with a favourable risk/reward ratio, risking only 2% of your capital for a single trade and having a stop loss to cut the losses early for every trade that you enter. For limiting the risk per trade, you should pay attention to position sizing and lot size which is again related to the leverage ratio and account balance.
Demo Trading
One thing you can do to learn more about margin, leverage and other key concepts in forex trading is practising on a demo account where you are not exposed to any kind of risk. But at the same time, you get an opportunity to trade in real-time market conditions as the demo account replicates the data that you get on a live trading account. Even though demo trading is risk-free, you can devise your risk management plan based on the trading results you get at the end of demo trading. This way, you can trade better on a live account later on.
Summary
To sum it up, trading in the forex market can be very rewarding when you learn to keep yourself safe from unwanted losses. Mastering the concept of margin and optimal utilisation of leverage is essential to succeed in your trading career.
