Forex Trading Margin: What is it and how it works

In this article you will be able to find answers to your doubts regarding margin in forex. Among the topics covered you will be able to find:

• What is margin in forex and how it works
• How much margin you can use
• How much margin is offered by brokers
• How to calculate margin
• What margin is best to use
• How to increase the available margin

What is margin in forex?

Forex margin is the collateral, typically expressed as a %, required to open & maintain a position in foreign exchange trading. It allows traders to control larger positions using less capital, thus amplifying potential gains/losses. Calculated as: Margin = (Trade Size/Leverage) x 100, it serves as a security deposit for brokerages.

In other words, margin allows traders to open forex positions larger than their available funds.

If the broker offers a 10% margin on forex, it means that the forex trader only has to use 10% of the capital needed to open a trading position of a certain volume (i.e., $10 to open a $100 position).

So margin is in fact a loan that the forex broker gives to its traders, with all the pros and cons of a loan.

Margin allows traders to amplify gains and losses (increases risk), and at the same time the broker reserves the right to charge a variable interest rate depending on trading volume and market conditions.

Anyway, you don’t have to necessarily calculate forex margin yourself, as you can rely on online tools such as the forex margin calculator provided by XM.

How does margin trading work in forex trading?

In forex there are different types of margin with different functions, but they can all be classified as amounts of money that forex brokers require the trader to pledge in order to access or keep the loans provided to trade higher amounts of money in the financial markets.

The types of margin are:

• Initial margin: the margin required by the broker to open a position
• Variation margin: the margin required to hedge against market fluctuations
• Maintenance margin: the minimum margin required to keep positions open
• Free margin: the margin that the broker can still commit to open trading positions.
• Margin call: safety margin to avoid automatic position closure

To better understand how they work, you can follow this example.

1. A trader (whom we decide to call Mark) decides to open a forex trade using margin to amplify his purchasing power. He has an account balance of $1,000 and wants to trade the EUR/USD pair. He is based in the European Union, so his broker is offering him a 1:30 leverage
2. With 1:30 leverage, Mark can control a position worth 30 times his initial investment. In his case, he can control a position worth 3 mini lots, or $30,000 ($1,000 x 30).
3. Mark decides to buy 1 mini lot (10,000 units) of EUR/USD at 1.1000. On paper, his position is worth $11,000 (10,000 units x 1.1000).
4. To open the position, the initial margin requirement is calculated as: Position size / Leverage. In this case: $11,000 / 30 = $366,67.
5. Mark’s margin account is now split into two parts: on one side, $336,67 are now “locked” by the broker (maintenance margin), and on the other, he still has $633,33 as free margin (available for additional trades or to absorb potential losses).
6. As the EUR/USD price moves, the profit or loss in Mark’s account fluctuates. If the trade is profitable and Mark decides to close it, the margin deposit is released, and the profit is added to the trading account balance.
7. If the trade incurs losses that exceed the free margin, Mark may face a margin call, requiring him to deposit more funds or close positions to meet the maintenance margin.

In summary, margin in forex trading allows traders to control larger positions with a smaller initial investment, amplifying both potential profits and losses. Proper forex risk management is crucial to avoid excessive losses.

What are the risks associated with forex margin trading?

Forex margin trading risks include amplified losses due to leverage, leading to account depletion. Market volatility can cause rapid price fluctuations, potentially triggering a margin call. Forced liquidation may occur if traders can’t meet forex margin requirements. Additionally, a low margin ratio can magnify minor price changes, causing emotional trading decisions.

Leverage amplification: the lower the margin allowed by the broker, the more money they will be able to lend you for the same amount. If the broker requires you to have a 10% margin to open an order, that means you will only need $100 to open a $1,000 order. However, losing 2% on a $100 order in 1:10 leverage means losing positions of $20 (or ⅕ of your initial capital), not $2.

Market volatility: the forex markets are extremely volatile, and using margin amplifies this effect. Using high leverage, such as 1:500, means amplifying each price fluctuation by 500 times, thus increasing the chances of losing money.

Forced liquidation: when using margin, the broker will automatically close the user’s trades in case the margin safety required by the trading platform is not enough to make up for the losses.

Emotional trading: High leverage exacerbates minor price changes, leading to impulsive decisions. The psychological factor, in forex margin trading, is extremely important and is what distinguishes the best forex traders from novice trader who lets their emotions control them.

Interest rate risk: when margin is used, the broker charges commissions to cover its interest costs. These commissions are charged every night the trading position is kept open, which means costs will add on top of each other day by day, making profiting by trading harder.

To date, many brokers offer Negative Balance Protection. In extreme cases, when this is not available as a feature, the trader could find himself in debt with the broker if he loses more money than he has deposited in his margin account.

Although in many countries, including Europe, brokers are required by law to implement these policies and more policies to protect the trader, more than 70% of traders lose money when trading in the foreign exchange market and other derivatives.

The forex market is therefore among the riskiest markets in which to trade, but that does not mean it is impossible to turn out to be profitable. In fact, the best traders in the world think about how to manage risk before they even think about profit.

Can I trade forex without using margin?

You can actually trade forex without using margin by trading only with your own capital. In this case, you won’t use leverage, which means your potential gains/losses won’t be amplified. However, this also limits your trading capacity, as you can only open positions with the actual funds available in your trading account, resulting in smaller potential returns.

Forex trading is based on lots, which is a system that measures the amount of currency bought and sold in a trade.

A standard lot corresponds to 100,000 units of the currency bought/sold. So, if you open a 1-lot trade on EUR/USD, you are buying 100,000 USD.

This means that to trade 1 standard lot without leverage, you would need to have 100,000 units of the currency you want to buy in your trading account.

However, forex brokers over time have offered services that allow you to participate in the forex market with much less capital. As of today, in fact, there are brokers that allow you to open orders on currencies from just 100 units of currency (or 100 USD in the case of a trade on EUR/USD).

Then there are brokers like Oanda that do not use lot sizes to determine if a trader can or cannot open trading positions, but they rather use currency units. At Oanda, in fact, traders can open positions as low as 1 unit of their own account currency (e.g. 0,01 USD).

Below you will be able to find a table summarizing the lot size and the respective currency units.

The difference between margin and leverage in forex trading

Margin in forex trading is the collateral required to open & maintain a position, usually expressed as a percentage.

Leverage is the ratio of money borrowed to a trader’s own funds, enabling larger positions with less capital. Margin serves as a security deposit, while leverage magnifies potential gains/losses in a trade.

In other words, if a trader wants to open a 1 micro lot order on the EUR/USD forex pair he will need 1000 USD.

In this case, the trader may decide to use 1:10 leverage so that only 100 USD is committed.

Thus, the margin percentage for a 1:10 leverage is 10%, because the forex broker requires the trader to have at least 100 USD in order to “lend” him the remaining 900 in order to get to the 1000 USD order.

How much margin do forex brokers allow traders to use?

The margin allowed by forex brokers varies depending on the broker, regulatory environment, and trader’s experience. Leverage, which determines margin, ranges from 2:1 to over 500:1. For example, ESMA regulations limit retail clients to 30:1 for major currency pairs, while professional clients and traders outside the EU might access higher leverage.

The determining factor, then, is the forex brokers and the entity with which they are regulated.

Unless the broker is based in countries where trading is poorly supervised (such as Mauritius), the regulator requires the broker to comply with certain rules, including offering margin.

These rules apply only to clients considered “non-professional” (or retail). If the trader, according to certain parameters of experience and economic availability, manages to classify himself as a professional, then the forex broker will allow him to open orders with much lower margins than retail traders.

In contrast, forex brokers based in countries such as Mauritius do not distinguish between retail and professional traders and do not impose explicit limits on brokers to meet in terms of the margin and leverage they can offer their clients. As a result, it is not uncommon to see leverage in excess of 1:500.

Forex major pairs VS minor and exotic forex pairs

The maximum leverage allowed by brokers on forex pairs is not always the same. In fact, depending on the classification of the forex pair, the leverage may be higher or lower than the maximum leverage allowed.

Forex pairs are classified into:

• Major: if they transact in USD (EUR/USD)
• Minor: if they do not transact in USD, but still are major currencies (EUR/GBP)
• Exotic: if they transact in currencies of developing countries and/or with weak economies.

Forex brokers generally charge:

• a lower margin on major forex pairs
• a higher margin on minor and exotic pairs.

This is because non-major pairs are more volatile and less liquid, so they are riskier to trade, and consequently providing the same leverage as major pairs could be detrimental to traders.

In this table, you will be able to find the difference in leverage and margin on major, minor, and exotic pairs for regulated forex brokers in Europe, the UK, and Australia.

*Please note that the maximum leverage and corresponding margin levels for professional clients can vary based on the broker’s policies and regional regulations. The values provided here are for illustrative purposes and may not accurately represent specific brokers’ offerings.

Forex margin VS other markets

Forex brokers not only offer currency trading but often also offer derivatives on other markets such as indexes or stocks.

The margin required for each market is in fact variable and depends both on the regulation of the broker and on the broker itself.

In fact, taking European forex brokers as an example, the margin percentage required for different markets are as follows:

• Indices: 5%
• Commodities: 10%
• Stock Market: 20%
• Cryptocurrencies: 50%

It must also be considered that there are exceptions.

One of these is gold, which, unlike other commodities, generally requires a minimum margin of 5%.

Another example is non-major world indices that generally require 10% margins instead of 5% like other indices.

Non-major indices are defined as all indices other than FTSE 100, CAC 40, DAX 30, Dow Jones, S&P 500, NASDAQ, Nikkei 225, ASX 200, EURO STOXX 50

*Please note that the maximum leverage and corresponding margin levels for professional clients can vary based on the broker’s policies and regional regulations. The values provided here are for illustrative purposes and may not accurately represent specific brokers’ offerings.

What is the best margin for trading forex?

The best margin for trading forex depends on individual risk tolerance, experience, and trading strategy. Lower margin usage (lower leverage) reduces risk and potential losses but also limits potential gains. New traders should start with lower leverage, while experienced traders may adjust margin usage according to their risk management plans.

In fact, the choice of margin depends primarily on the risk/return ratio of the trade, and how much the trader is willing to lose within his margin trading strategy. This is vital to have a good risk management and avoid margin calls.

Starting the reasoning from the margin is wrong because it can lead to biased decisions that could be wrong and harmful.

The correct way of reasoning is as follows:

1. How much am I willing to lose?
2. What is the maximum risk I am willing to take?
3. What type of lot is best to use?

How much are you willing to lose: the percentage should be no more than 3% of your total trading account (which is already a big percentage according to professional traders). If you have a $1,000 USD account, you should not risk more than $30 per trade.

Trade risk: Before you even think about gains, you need to think about what could go wrong. You then need to decide where to set the stop loss order so as to limit any losses.

Trade Volume: most forex brokers will allow you to choose the volume in lots with which to open the order. Generally, if you have a trading account with less than 1,000 USD or are new to margin trading, opening orders of 1 micro lot is the best choice because it requires a smaller initial margin, and therefore losses will also be small. More experienced traders with more capital may also decide to open standard 1-lot orders.

To calculate trading volume you can use this formula: [(C*P)*L]/(SL*10)

P = Percentage you are willing to lose out of total equity (usually maximum 2-3%

C = Total capital

L = 1 standard lot (100000 currency units)

SL = Maximum loss in acceptable pips

Practical example: Suppose Mark decides to risk 2% of his total capital of 1000 USD, which is $20 USD, and he doesn’t want to lose more than 50 pips for this trade. Using the formula above we can calculate the trading volume that Mark can afford on the trade he wants to open:

[(1000 USD * 2%) * 100000 currency units] / (50 pips * 10) = 4000 USD (4 micro lots).

Now Mark can decide to use different leverage based on the risk/return ratio of the trade. In other words, if the trade (based on the technical analysis performed) has a high chance of turning out to be positive, Mark may decide to apply higher leverage so as to amplify his gains.

Conversely, if Mark thinks that the risk/return ratio is close to 1:1, he may decide to apply more conservative leverage.

Pros and cons of margin trading

Pros

• Increased purchasing power
• Allows you to trade markets that would otherwise be inaccessible
• Allows for flexible trading
• Can increase earnings

Cons

• You can lose more than you invested
• Interest is charged on money lent by the broker
• Using leverage can cause emotional stress
• Can increase losses