These requirements are set by brokers and are based on how much they are willing to risk while at the same time adhering to restrictions placed by regulatory bodies.
Above is an example for the margin requirement for GBP/USD under the heading; “Deposit factor”. It is important to note that margin is not a transaction cost (a must pay fee by the trader), rather, it is a portion of the account equity that is set aside and allocated as a margin deposit. Also, the amount of margin that would be needed to hold a position is explicitly determined by the trade size.
Note: As trade size increases, traders tend to move to the next tier where the margin requirement (in monetary terms) will equally increase as well.
Takeaway: Margin requirements can also be increased temporarily during periods of high volatility or they’d lead to releases of economic data which in turn can lead to a greater than usual volatility.
Now, to avoid a margin call, traders need to make sure that the trading account is funded sufficiently and an easy to keep track of the status of their trading account is through the FX margin level:
Forex margin level = (equity/margin used) x 100
Take for instance, a trader who has deposited $10,000 in the account and currently has used $8,000 as margin, the forex margin level will equal 125 and this is above the 100 level. Note that, if the forex margin level dips below 100, the broker will prohibit the opening of new trades and may place you on Margin call.
It is quite necessary that traders understand the margin close out rule specifically indicated by individual brokers to avoid the liquidation of current positions, because when an account is placed on margin call, the account will need funds as soon as possible to avoid liquidation of current open positions. This is done by brokers to revive the account equity back up to the acceptable level.
This is a mechanism put in place by your Forex broker in a bid to secure your used margin. Recall that your used margin is allocated by your broker as the collateral for funds borrowed from your broker. It is a margin call, when your free margin falls to zero and all that is left in your trading account is your used or required margin. Simply put, it is what happens when a trader has no more usable or free margin. A margin call is likely to occur when traders commit a large portion of equity to used margin, leaving not just enough to absorb losses. Once this happens, your broker is liable to close all open positions at current market prices as a mechanism to manage and reduce their risk effectively.
Some causes of Margin call include:
- Holding on to a losing trade for a long time and this depletes usable margin.
- Over-leveraging your account along with the aforementioned reason
- An account with little or insufficient funds which would force you to over trade with little usable margin
- Trading intermittently without having breaks or stops, especially when price moves aggressively in the opposite direction.
What Happens in the face of a Margin Call?
Here is a graphical representation of a trading account that runs a high chance of receiving a margin call:
Deposit: $10 000
Number of standard (100k lots traded): 4
Margin percentage: 2%
*Used margin: $9 000
Free margin: $1 000
The used margin is calculated as follows with the EUR/USD at 1.125:
Trade size x price x margin percentage x no. of lots
$100 000 x 1125 x 2% x 4 lots = $9 000
In this example, if the market moves more than 25 points (not accounting for spread) the trader will be on margin call and have the position liquidated ($40 per point x 25 points = $1000).
For simplicity, this is the only position open and it accounts for the entire used margin. It is clear to see that the margin required to maintain the open position uses up the majority of the account equity. This leaves a free margin of only $1000.
Ways to avoid a Margin call
- Do not over-lever your trading account. Reduce your effective leverage. It is recommended you use a ten to one leverage, or less.
- Exercise prudent risk management by limiting your losses with the use of stops.
- Keep a healthy amount of free margin on the account in order to stay in trades. It is recommended that you use no more than 1% of the account equity towards any single trade and no more than 5% equity on all trades at any point in time.
- Trade smaller sizes and approach each trade as just one of a thousand insignificant, little trade.
After quite a well detailed explanation of Margin in Forex trading, let’s see the various elements that make up your trading account and how they are being affected by the leverage ratio and margin requirement. Understanding how these elements are intertwined is quite necessary, in order to create a sound risk management strategy.
- Equity: This is simply the balance of the trading account after adding current profits and subtracting current losses from the cash balance i.e. the total amount of funds you have in your trading account.
- Used margin: A portion of the account equity that is set aside to keep existing trades on the account.
- Free Margin: The equity in the account after subtracting margin used i.e. your total equity minus any margin used for leveraged trades. For example, if you have equity at $1,000 and your used margin is $100, your free margin would amount to $900. It’s important to understand that your free margin increases with profitable positions, but decreases with your losing positions. Once the free margin drops to zero or below, your broker will activate the so-called margin call and close all your open positions at the current market rate, in order to prevent your equity from falling below the required margin.
- Forex margin level: This provides a measure of how well the trading account is funded, by dividing equity by the used margin and multiplying the answer by 100.
- Balance: Your trading account balance equals your equity only if you have no open positions. In other words, unrealized profits and losses do not affect your balance. Your account balance will only change when you close your trades and the unrealized P/L become realized.
- Unrealized P/L: These are all profits and losses made on open positions. They have an impact both on your equity and free margin. Once you close your open positions, unrealized P/L become realized.
These categories can be expressed in a relationship which follows a formula:
Equity = Margin + Free Margin OR Equity = Balance + Unrealized Profits/Losses
Conclusively, when trading on a margined account it is crucial for traders to understand how to calculate the amount of margin required per position if at all it is not provided on the deal ticket. If you are new to forex trading or a forex enthusiast, get acquainted and update yourself with everything about forex on fxcryptonews.com.