Margins are important enough in Forex trading that you should know in some detail why they are important, how they are reckoned and the crucial role that they play in the use of leverage. Margin determines the extent of leverage but, to gain a better understanding of how they work, let us assume that you are using no leverage and only your margin is available to determine the size of your positions and trades.
Let us say that your account is worth $10,000.00. and that you wish to buy 1000 Euros against the U.S. dollar. If the EUR/USD rate is 1.3000, you will have to pay $1,300.00 to buy 1000 Euros. If you are taking a long position, you will have to put up a margin of $1,300.00 from your $10,000.00 investment in order to establish the position. When the position is closed, this $1,300.00 will come back to your account to be available for new positions. Taking the same example further, if your broker allows you leverage of 100: 1, the same margin of $1,300.00 will enable you to buy 100,000 Euros.
If you have $10,000.00 in your account and no open positions, your account balance will be $10,000.00. On the other hand, your equity is defined as your account balance plus the floating profit or loss on your open positions. For example, if you have a floating profit of $1,000.00 on your open positions, your equity will be $11,000.00. If you have a floating loss of $1,000.00 on your open positions, your equity will be $9,000.00 On the other hand, if you have no open positions, your equity will be the same as your account balance.
Free margin can be calculated by taking your total equity and reducing the margin that is required to maintain your open positions. If you have been no open positions, the entire balance in your account represents your free margin which can be used to establish new positions. Let us assume that your account balance is $10,000.00 and that you have $1,000.00 in floating profits on your existing positions and require $500.00 in margins to maintain these open positions. Your free margin will work out to the difference between your equity ( $10,000.00+$1,000.00= $11,000.00) and the margin that is required for your existing positions of $500.00 and the figure is $10,500.00. Another important number is the margin level which is the ratio of equity to margin. If your broker allows you leverage of 100: 1, your margin level limit is 100% and if you are at this limit, you can close existing positions but your broker will not allow any new positions unless you put up more margin. If the market continues to move against you, the broker will have to start closing your existing positions when your margin levels reach what is called Stop Out Level. This level is typically around 5% and triggers the beginning of the closing of your open positions and the process will commence with the positions showing the largest losses. This happens because your broker cannot allow losses beyond what you have on your own account.
A margin call is a notification from the broker to a trader who holds a margin account with him to the effect that the margin is on the brink of complete depletion and that the trader is required to deposit additional funds in order to rectify the situation. If this does not happen immediately, the broker will reserve the right to close existing open positions without any further reference to the trader. This generally happens when the trader accumulates trading losses on a continuous basis and is left with virtually no free margin or equity. The trader can choose to deposit extra margin if he believes that the trades will eventually be profitable for he can choose to close positions himself without the broker having to do so.
Margin trading with limited capital
In the old days, you needed to have a considerable amount of investment capital in order to trade in the Forex market. The market has now changed and evolved so that you can trade even on a modest budget though caution remains the key to success in trading. Because your broker is compensated by the bid/ask spread, he does not charge separate commissions which will add to your cost of trading. There are plenty of brokers who cater to traders with limited means and do everything that they can to help the trader. If you choose your broker wisely, you will find trading that much easier.
Forex trading vs. Currency Futures
The two principal trading options are the spot markets ( often known as the FX markets) and the currency futures market of which the most important is the Chicago Mercantile Exchange. Each one has its pros and cons some of which are outlined below. In terms of government regulation, futures brokers must follow regulations laid down by bodies such as National Futures Associate (NFA) and the Commodity Futures Trading Commission (CFTC). Because the FX markets are global in nature and do not have a fixed geographical location, no means of regulating them has yet been devised and this is a factor that you must take into account before you decide to trade on the spot market. Very often, if your broker has a dealing operation himself, he could well be the counterparty to your trade and this has been compared to playing poker against someone else with your cards open. Moreover, though the market is too large to be manipulated as such, nothing rules out manipulation on the part of your broker especially because you have no access to what is happening in the real market. Obviously, this does not apply to exchange trading futures where the price is transparent and the exchange itself is the counter party for your trades. However, you will have to pay a commission on every trade executed on your behalf by the futures broker. You will also be able to get much higher leverage on the spot markets than you would get on the futures markets.