The Forex market offers its participants the potential to trade on margin. The ability to trade on margin is one of the attractive - but at the same time risky- features of forex trading. Essentially trading on margin allows the forex trader to trade on borrowed funds. The degree to which the trader can borrow will depend on the broker they are using and the leverage or gearing they offer.
In the Forex market the term margin is the amount of money required to open a leveraged position, or a contract in the market.
Without leverage a trader placing a standard lot trade in the market would need to post the full contract value of $100,000 in order to have his or her trade executed. Leverage allows a trader to place the same $100,000 contract for an amount of margin (determined by the set level of leverage). For example, an account at 1:100 leverage would require $1,000 of margin to place a $100,000 trade.
By offering leverage to the trader, the brokerage is essentially allowing the trader to open a contractual position with considerably less initial capital outlay. Without leverage, a trader placing a standard lot trade in the market would need to post the full contract value of $100,000. With a leverage of 1:100, the trader can in fact open the position with an initial leverage of USD $1,000.
Trading Forex on margin should be used wisely as it magnifies both your potential profits and potential losses. Remember, the higher the leverage, the higher the risk.
Forex traders are subject to the margin rules set by their chosen brokers. In order to protect themselves and their traders, brokers in the Forex market set margin requirements and levels at which traders are subject to margin calls. A margin call would occur when a trader is utilizing too much of their available margin. Spread across too many losing trades, an over margined account can give a broker the right to close a trader's open positions. Every trader should be clear on the parameters of their own account, i.e. at what level are they subject to a margin call. Be sure to read the margin agreement in the account application when opening a live account.
Traders should monitor margin balance on a regular basis and use stop-loss orders to limit downside risk. However, due to the extreme volatility that can be found in the Forex market, stop-loss orders are not always an effective measure in limited downside risk. There is still the possibility of losing all, or more, of your original investment.
Every trader should know what level of risk they wish to take. Whilst the attraction of taking on a big position to receive increased profits is quite clear, it should also be noted that a slight movement in the market will result in a much higher loss in an overly leveraged account.
Traders always have the option of applying a lower level of leverage to an account or transaction. Doing so may help manage risk, but bear in mind that a lower level of leverage. will mean that a larger margin deposit will be required in order to control the same size contracts.
To calculate the margin required to execute 1 mini lots of USD/CAD (10,000 USD) at 1:100 leverage in a $500 mini account, simply divide the deal size by the leverage amount e.g. (10,000 / 100 = 100). Therefore, $100 margin will be required to place this trade, leaving an additional $400 marginable balance in the trading account.
Most Forex trading software platforms automatically calculate FX margin requirements and check available funds before allowing a trader to enter a new position.
In the above example we had a $500 account. In order to open the position above we were required to have initial margin of $100. This is referred to as used margin. The remaining $400 is known as the free margin. All things being equal, the free margin is always available to trade upon.
The trading platforms used have become very sophisticated calculating these figures in real time so there is no need to calculate them manually.