Every trader has seen many times the mysterious values such as Margin, Free Margin and Level in the trading platforms. Do you know what they mean? What are the benefits of their practical use? How are they connected to the leverage? Even experienced traders are often confused about these things, let alone the budding traders. I think we should discuss these concepts since ignorance always leads to losses.
Before reading the article and writing your questions in comments section, I recommend to watch this video. It’s not long, but covers biggest part of questions on the topic.
WHAT IS THE MARGIN?
Nowadays most transactions on the stock exchange are made to get a short-term profit and any speculator, as we know, has always been striving to make money on the discrepancy.
If you want to produce a sufficient turnover, you will need a large seed funding. So here margin trading comes to your aid, that is, trading using borrowed funds taken under a certain guarantee (or margin). In case you don’t have enough money to open a sufficient position or you want to increase the trade turnover, the brokers offer a short-term loan service, which allows you to open positions that are much larger than your seed funding.
Unlike a simple loan, the size of the margin loan can be several hundred-folds larger than the size of the guarantee. In this case, the leverage reflects the ratio between actual transaction volume and the size of the collateral. Different companies can offer different loan terms depending on the market and the perceived risks. Usually, the leverage on the Forex market is from 1:25 to 1:1000. Consequently, the greater the leverage value, the smaller the collateral required to open a position of the same volume.
MONITORING THE VALUES IN THE TRADING TERMINAL
You can find free margin value and the current level in any trading terminal (MetaTrader 4 or MetaTrader 5) along with the values of balance, equity and aggregate margin for open positions.
Free margin is the free funds available for opening new positions. It is the difference between the amount of money of the deposit and the amount of the reserved funds.
The level is the ratio (in percentage terms) between the funds (account equity) and the used margin.
You must remember two key limits on the Margin Level, which are Margin Call and Stop Out. When you reach the Margin Call level, you will no longer be able to open new positions since free funds will not be enough to cover another collateral. Usually, the brokers set this value to 100%.
If the margin level goes even lower and reaches the Stop Out value, the broker will close your positions, starting with the most loss-making ones. That is the most dangerous thing about collateral trading. The broker does not want to lose his money so he will close your positions before you go to the red.
Usually proper capital management allows to avoid such things. A budding trader does a typical mistake of opening a too large lot with a large leverage. That’s the reason why even a slight rate change immediately results in the Margin Call. The budding traders also often forget to set the Stop Loss orders, which is why the positions that have gone far into the red, have a chance to close on the Stop Out.
CALCULATION OF THE CRITICAL LOT
The leverage size directly affects the maximum size of the position available for opening. Let’s suppose that you want to open a new USDCHF position. Since the standard Forex lot equals 100,000 units of the base currency and the leverage is 1:100, the collateral for opening one lot for the USD/CHF pair will be $1,000. If you have $10,000 on your account, you may open up to 10 lots. At the same time, if you have a leverage of 1:200, you can open twice as many, that is, 20 lots.
THE COMMON FORMULA
Remember that different tools have different values of the lot. In case of the Forex market, you may bring the base currency of the pair to the deposit currency to calculate the value of a single lot.
Let’s consider one more example. Imagine that the EURUSD currency rate was 1.09992 at the moment when the position was opened. Hence, one standard lot for the EURUSD currency pair will cost $1099.92 with the leverage of 1:100. That is, you could have opened 9,09 lots having the same $10,000 on your deposit.
You can use the margin calculator if you don’t want to calculate it manually.
We don’t recommend you to use all available funds to open the positions. It is a good practice to trade a certain piece of the deposit (2-3% is recommended) so that you have a “safety net”. Otherwise, any error may cause you having not enough funds on your account and you will lose the deposit by the Stop Out. Therefore, when you open a position, you should calculate accurately the size of the maximum possible loss and, if possible, use the loss limiters (the Stop Loss orders).
THE REAL-LIFE EXAMPLES
Let’s consider and solidify the knowledge we have just studied on the real life examples. Open a new demo account for convenience. Enter the deposit amount of $10,000 with the leverage of 1:100. Then open a transaction with one lot at the rate of 1.0919.
The margin is a thousand times larger than the rate at the leverage of 1:100. Free margin is the difference between the balance and margin, and constantly jumping since the current profit/loss is added to this difference. The level value displays the ratio between the free margin and the margin.
So if one lot is about $1100, the free margin is approximately $8,800, then you can open about eight additional lots. You can open one more position over eight lots and that is our limit for the current deposit. In case your positions seem to be profitable, you can use the free margin from the non-fixed profit to open new positions. However, we do NOT recommend you to do that.
Let’s consider a different situation. Open a demo account similar to the previous one but with the leverage of 1:500. Open the position with one lot at the same rate. So the margin is five times less than at the leverage of 1:100. That is, the larger the leverage, the less money you need for collateral and the more positions you can open. In this case, you have the opportunity to open approximately 43 additional lots.
You can improve your trading by using the financial leverage principle properly. The large leverage allows you to manage risks smoothly and also provides new trading opportunities. You can trade the rate difference having only a small percentage of the full contract value on the account. The risks are limited by a small amount of collateral, which will return to your account with the profit received in case of a profitable outcome of the transaction. You should never forget that the larger the leverage, the greater the risks of the loss.
Therefore, before studying the margin trading, make sure that you fully understand all the related trading risks.
Author of Original Text: Alexey Vergunov from tradelikeapro.ru