How margin works in Forex
Forex is a market where there’s not the actual delivery of the purchased goods, or to put it in technical terms of the underlying. In Forex you operate with margin.
Margin or delivery of the underlying
For instance, in a normal purchase where there is the underlying asset delivery, such as in the stock market, when you purchase some shares this is what happens:
Suppose you have 10,000 usd on the account and you buy 1,000 shares of the XYZ inc. at € 5, for a total of 5,000 usd (1,000 shares x 5 usd).
What it will happen on a practical level?
On a practical level, of the 10,000 usd stored on your account, 5,000 usd would end up in the market for the purchase of the XYZ inc., and 5,000 usd would remain on the account. The 1,000 XYZ inc. would be loaded into your deposit (securities portfolio), linked to the account with which you are trading in securities (delivery of the underlying). So right after your purchase, you’d be left with 5,000 usd on the account and 1,000 shares of XYZ inc. on the portfolio, for an equivalent, at the purchase price of the market at that time, of 5,000 usd.
At this point, the value of your investment, that has been delivered within your securities portfolio, will fluctuate depending on the increasing or decreasing of the market value of the XYZ inc. shares.
If the market value of the XYZ inc. shares would increase, also the value of the deposit would increase, and once the shares would been sold, you will find yourself again with an empty security portfolio, as before the purchase, and your account would be increased by the difference between the sales price and the initial purchase price.
This is what happens when you work in a market that involves the delivery of the underlying. In a market in which this delivery is not provided, just as in Forex, you will work with margin.
But what is margin?
The margin is the amount of money needed as a “good faith deposit” that the broker asks for letting you open an operation.
The broker takes your margin deposit and puts it together with all the other margin deposits (those of other customers who are operating in the meantime), thus creating a “super margin deposit” with which he is able to place large orders on the interbank network.
The amount of margin required for each transaction is inversely related to the leverage allowed by the broker. The higher the leverage, the smaller the margin requirement (the capital locked into the account as a guarantee).
Having a leverage of 100:1, the margin required by the broker will be nothing but the hundredth part of the investment you’re making.
Therefore, if you have a 1,000 usd account you can open maximum a position of 1 lot. The equivalent in the market of 1 lot is 100,000 usd and 1,000 usd is the hundredth part that, it is said, will be blocked as margin.
Following this logic, we can also say that you can open at the same time a maximum of 10 positions of a minilot (0.1 lot). A minilot corresponds to an equivalent value on the market of 10,000 usd. If for each position will be frozen on the account the hundredth part, 100 usd per position will be blocked as margin, which for 10 positions will always do our maximum of 1,000 usd.
Following this reasoning, it goes without saying that you can open at the same time up to 100 positions of a microlot (0.01 lot).
The margining is often expressed as a percentage value relative to the total amount of the position.
For example, most of the brokers on the Forex market will tell you that they require a margin of 2%, 1%, 0.5% or 0.25%.
Using the percentage margin required by your broker, you can calculate the value of the maximum leverage with which you can manage your trading account.
We often hear about it, but to be precise, we must say that in Forex the Margin Call does not exist. In other markets the Margin Call is the request to the client by the Broker of a payment of additional funds in order to cover the minimum margin requirement for the maintenance of losing positions.
In Forex the brokers calculate at any moment what are your margin requirements, and if by chance, even for a few seconds, your losing operations should go beyond that level, the broker would close them automatically. In Forex market the Brokers do not “call” you to let you know, in Forex the Brokers closed them directly.
Knowing leverage and margin is useful for you to understand the correct lot size that the open positions should have. For this reason, there are a number of logical and mathematical reasoning that I suggest you to do now with me, because it will help you get well acquainted with the weights to give to your positions.
Margin in practice
If you know:
- The account balance: 3,000.00 usd
- The maximum leverage that the broker gives you: 400:1
You can discover:
– The maximum lot size that you can use:
$ 3,000.00 of capital on the account x 400 of maximum leverage allowed by the broker
3000 X 400 = $ 1,200,000
$ 1.2 million of capital / $ 100,000 of capital that corresponds to 1 lot = 12 lots
So, under these conditions, with an account of $ 3,000, you can open transactions for a total maximum lot size of 12 lots.
– The percentage of margin that is required by the broker for each transaction will be:
$ 3,000.00 of capital on the account / $ 1,200,000 maximum equivalent on the market
(3,000 / 1,200,000) x 100 = 0.25%
Another example of the calculation. If you know:
- The account balance: $ 3,000.00
- The percentage of margin required by the broker for each transaction: 0.25%
You can discover:
– The margin of capital that the broker will immobilize for each transaction:
for example, for a transaction of one minilot, that is equivalent on the market to
$ 10,000.00 x 0.25% (percentage of margin required by the broker)
10,000 * 0.25 = 25
$ 25 is the amount of capital that the broker will block on the account in the event of input of an order of 0.1 lot ($ 10,000 equivalent) on the market.
– Using the sample data of the previous calculation, you can find also the maximum leverage allowed by the broker for the account:
$ 10,000.00 of equivalent on the market for a position of one minilot (0.1 lots) / $ 25 of margin required by the broker in the form of capital
10,000 / 25 = 400
That is, a leverage of 400:1. A leverage of 400 times the capital held on the account, for the single transaction.
So hypothetically having $ 500 on the account you can operate up to a maximum of $ 200,000, or 2 lots.
– The maximum lot size allowed by the broker for the capital in your account
$ 3,000.00 on capital on the account x 400 that is the maximum amount of leverage granted by the broker
3,000 x 400 = 1,200,000
That is 12 LOTS
If your broker will require a margin of 2%, you will have a 50:1 leverage. And here is the other most popular types of levers offered by most brokers: