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The Forex market is famous for its great variety of financial instruments available for trading, among which currency pairs are prevalent. Being the most liquid market in the world, Forex gives incredibly large opportunities for capital growth daily, which is made possible by the presence of leverage, which increases the level of margin in the trading process. But what is the margin level, and how does it work?
This article will shed some light on the margin level in Forex trading and how it is calculated. In addition, you will learn what free margin is and how it is determined and understand the relationship between leverage and margin. In the end, we will give you some valuable tips on how to use margin forex trading correctly.
The margin level reflects the ratio of the investor's initially available cash and the amount of leverage.
Margin level is the leading indicator reflecting the possibility of opening new deals with leverage.
When working with margin trading, it is necessary to use stop loss orders, not to use the whole deposit for opening transactions, and also not to use high leverage.
What is Margin Level in Forex Trading, And How Is It Calculated?
The concept of margin is fundamental not only in Forex but also in other types of trading, describing the situation when a trader or investor in the process of trading activities uses borrowed funds from the Forex broker (stock exchange) and thereby increases the level of initially invested deposit. The margin indicator is expressed as an absolute ratio of the amount of initially invested investment funds for buying (long) or selling (short) any financial asset to the amount of borrowed funds, taking into account the specifics of the purchased asset, its volatility, and other indicators, including the level of the trading volume.
Margin is considered to be the share of cash in an investor's account that is used as collateral to open a position. It is intended to cover a part of the risk created by a market participant for a broker. Most often, it is a share of a trading position expressed as a margin percentage, which can be expressed by the formula:
Margin = Position Volume × Contract Size/Leverage
The formula shows that margin is a volatile indicator because its value depends on specific trading conditions. In particular, the level of leverage is directly proportional to the level of margin. The margin level is determined based on the initial amount of the investor's deposit and is calculated individually depending on the type of purchased instrument, which can be visualised in the form of a formula:
Margin level = (Funds/Margin) x 100
Margin levels in trading on financial markets, mainly Forex, are used to assess the possibility of opening new deals. When this indicator is equal to zero, it means that, at the moment, the investor has no active positions. On the other hand, if it is 100%, then the account funds are equal to the margin level. In this case, the broker can prohibit opening new trades until the account is replenished by the required amount or the level of floating income from other, already opened trades is increased.
Suppose the trader's forecast within the investment strategy framework does not come true, and the asset's price is in the opposite direction to that expected. In that case, a negative margin arises in the trading account. A negative margin occurs when the market value of an asset becomes lower than the amount borrowed for its purchase. In this situation, when the price falls (or rises when trading short) below/above a certain level, the trader receives a margin call– a special notification of insufficient margin collateral with a request to deposit additional funds into the account. If this notification is ignored, the broker forcibly closes margin positions to avoid large losses.
As a rule, both beginners and professional traders use special services to determine the margin level in Forex trading. This helps them calculate the Forex margin required level and its other components. One such service is the Forex margin calculator, which has a built-in formula for calculating the risk coefficient, as well as the ratio of the level of initial investments to the level of borrowed funds.
The Forex market leads the way in terms of the level of leverage brokers can provide to their clients for trading currency pairs.
What is Free Margin, and How to Determine It?
The concept of free margin is inseparable from the concept of margin, and in the context of Forex trading it describes the amount of funds on the margin account of an investor, which are not involved in transactions and can be used for further trading or withdrawal. In other words, the free margin in Forex trading is an indicator of the stock of funds on the account, which can be used to open additional trades. If there are no open trades on the account, the free margin in Forex trading is equivalent to the account balance. In this case, there is no danger of unfavourable circumstances that may cause the liquidation of a position as a result of insufficient margin required to open positions.
Free margin is an important indicator. Experienced traders use it as a reserve and spend it only when absolutely necessary. If the free margin in Forex approaches 0, the trading account is in a dangerous position. In this case, the broker may use a margin call to prevent losses. If we define what free margin on the exchange is, taking into account the practical aspect, then we are talking primarily about manoeuvrability. This is explained by the fact that free capital can be redirected to save the situation with a losing position or help quickly respond to market changes without fixing the result of unprofitable transactions.
The free margin level can be calculated using the formula below.
Free Margin = Equity - Margin
Thus, it follows that the free margin level is defined as the amount of cash available for the purchase of financial assets minus the margin available for the use of borrowed funds. Therefore, the free margin level should be systematically monitored, as there is always a risk of opening many transactions or positions with significant volumes. Since there is always a need for free funds, and for each transaction, there is a probability of temporarily going into deficit, in the absence of a free margin on the trading account, all positions will be automatically closed in a forced manner.
Ultimately, free margin provides the opportunity to adjust the investment strategy according to market sentiment to avoid the possibility of losing all capital. Moreover, the free margin level serves as a starting point for planning entry and exit points, as it directly affects the overall state of the trader's trading account and helps to analyse the possibility of adjusting the leverage level according to the degree of willingness to take risks.
On the other hand, since leverage is the main instrument, the regulation of which is equally directly proportional to the level of margin, i.e., borrowed funds, there is a direct relationship between the two, in which they influence each other, which we will discuss in detail in the next paragraph.
How are Margin Level and Leverage Related?
As mentioned above, the level of required margin and the level of leverage used to increase the possibility of obtaining higher profits have a direct correlation, which is expressed as follows: the higher the level of leverage, the higher the level of margin required to open new positions and to cover the debt obligations to the broker in case of unsuccessful forecasts. As the margin requirement is a conditional value of the necessary amount for the possibility of making new deals on the market, the amount of equity available for trading is of primary importance for the possibility of starting leveraged forex trading.
Leverage is a lever that increases the purchasing power of our deposit. This mechanism is provided at the expense of the broker's funds, or more precisely, the liquidity provider with whom he co-operates. The leverage mechanism is straightforward – the more leverage, the more funds an investor can use in trading. Simply put, leverage is like a consumer loan from a bank, only cheaper, and the lender often risks only the funds in his account. At the same time, the level of leverage can be within the limits set by each particular Forex broker.
When deciding on the choice of leverage, the broker assesses the state of your portfolio and calculates the risk for each position. In forex trading, there is also a risk level for each currency pair, which is periodically reviewed to take into account volatility and political events. Leverage is an opportunity to start trading with a smaller initial investment and potentially higher profits. However, leverage in volatile markets can lead to rapid liquidation, especially when using high ratios such as 100x leverage.
An increase in leverage may indicate a change in the trader's strategy.
Most typically, leverage is increased to open transactions in large volumes or increase the number of transactions and possible profits. This risk is justified if a trader is experienced and confident in his trading strategy. Thus, investing $1000 in buying USD/EUR currency pair with the leverage of 20x, the total amount of the indicated funds increases 20 times and amounts to $20 000, which ultimately gives an increased probability of getting additional income in case of the successful forecast, but on the other hand, gives the same probability of losing both borrowed and own funds in case of the unsuccessful forecast. It follows that the use of margin trading, in general, has both positive and negative sides, which can be balanced only with the help of deep expertise in the market and an accurate assessment of market sentiment.
Forex Margin Trading Tips
Forex trading is considered a highly lucrative tool for developing financial market skills to improve the investment experience. The great popularity of this market has become the basis for the creation of an entire industry, with many different brokers offering their clients access to the currency market.
However, due to inexperience on the one hand and the pursuit of big profits on the other, many traders make mistakes, particularly when working with leverage. Therefore, below, you will find several tips that will help you sharpen your skills in working with Forex margin trading.
1. Do Not Open Positions on the Whole Deposit
Trading with leverage is not only an opportunity to get valuable when working with margin mode and increase your deposit but also an opportunity to learn to predict more accurately the probability of movement of asset prices, which favours the development of an intuitive understanding of market functioning.
However, many beginners make a gross mistake at the first couple of trades, opening deals on buying/selling financial instruments using their entire deposit, which multiplies the risks of liquidation of such positions in case of inability to accurately predict and track the price behaviour, which eventually leads to margin calls and loss of capital. Forex market does not forgive mistakes, so you should thoroughly study the specifics of working with this market before increasing the volume of open transactions.
2. Don't Use High Leverage
The second, not less common mistake, which brings a lot of problems in the early stages of work with margin trading Forex traders, is the use of high leverage. The desire for significant income pushes new traders to rash actions, exposing their deposits to great risk, which, as it was mentioned in the article, grows in equal proportion to the size of leverage.
Forex brokers mainly offer a very flexible range of leverage for trading most currency pairs and other financial instruments. As a rule, this range varies from 20:1 to 1000:1 depending on the broker, which allows you to adjust the optimal ratio of expected profitability in relation to the potential risk of losing money as a result of an ill-advised investment strategy. Therefore, when working in the Forex market, it is worth refraining from using high leverage, especially when trading highly liquid and highly volatile currency pairs and financial instruments.
3. Use Stop-Loss Orders
Many beginners and experienced traders working with such a high-risk financial mode as margin trading forget entirely about safety measures when working with leverage, including a stop-loss order. A stop-loss order is an excellent tool to prevent unexpected financial losses and is used in any type of financial market. It is especially common in highly volatile markets such as crypto and Forex.
Stop-loss orders are possible when working with any amount and with any level of leverage. It is enough to set the necessary price level, which you consider to be the point when it is possible to sell the existing assets with a profit but without the risk of receiving a margin call as a result of the opposite movement of the asset price.
Margin trading offers great opportunities for novice and experienced investors, guaranteeing stable income using the right tactics and careful analysis. In turn, the margin level is the main indicator showing the ratio of the investor's own funds and borrowed funds, which helps to modify the investment strategy accordingly.