What is free margin in forex?
Free margin is the money in your trading account that’s available for trading.
Sounds simple, right?
Not so fast…
You can use leverage when trading forex. That’s a problem since it makes your free margin change quickly, which can end up triggering a margin call. That brings us to other common forex trading questions such as, “what is leverage in forex trading”, “how does impact free margin”, and “what is a margin call in forex”. Traders who don’t understand forex margin and leverage, tend to blow up their accounts quickly and lose a lot of money.
Forex traders who know how to use forex leverage correctly can make huge profits trading currencies.
What is leverage in forex trading?
Leverage allows you to enter trades by only putting down a small amount of money. Put differently, leverage is essentially a loan that gives you money to trade. When trading stocks, traders need to pay the full amount for what they want to buy. For example, if you want to buy $5k worth of shares of Apple, you will need to pay the $5k upfront.
Forex is different.
If you trade with leverage, it means you only must pay a small amount upfront. As an example, say your account is leveraged 200:1. This means for every $200 traded, you only need to fund $1 in your account. You can borrow up to 500 times your investment in certain countries, which is why you don’t need much money to start trading forex.
That said, governments are slowly reducing the amount of leverage you can trade with because they think it’s dangerous.
Here are the new leverage limits in Australia (check your own country’s leverage limits):
- 30:1 for major currency pairs
- 20:1 for minor currency pairs, gold or major stock market indices
- 10:1 for commodities (other than gold) or minor stock market indices
- 5:1 for shares or ETFs
- 2:1 for crypto-assets
US brokers only allow clients 50:1 leverage in forex, I believe.
Regulators couldn’t be more wrong about reducing leverage requirements. On the one hand, you can just sign up with international forex brokers to bi-pass your country’s restrictions. More importantly, leverage is only dangerous if you don’t know how to use it.
Digging deeper into forex trading leverage
I believe 10:1, or lower, is enough to trade successfully. But 50:1 is the ideal amount of leverage.
For example, imagine you want to open a forex account with $5k. That’s the maximum amount you’re comfortable to lose while learning forex trading. If you have 50:1 leverage, you would control $250k. That means you could take control of $250k worth of positions.
Do you see how this works?
You open an account with $5k and 50x leverage. The maths: $5k x 50 = $250k. This amount is called your total exposure. When you place a forex trade, your forex broker deducts the amount from your total exposure and that reduces your ‘free margin’. When you close your forex trade, the broker will return the money he held on margin. That might increase or decrease your available ‘free margin’ for other forex trades, depending on whether you have made a profit or a loss. (More on this later).
The problem in forex trading leverage
Leverage is ONLY a problem for uneducated traders!
It allows you to trade big with a small outlay. This increases risk for amateur traders.
One of my friends contacted me the other day. She wanted me to look at her trading account and was worried she’d done something wrong. I didn’t know she was even trading and asked her how much she put into her account. $5k was the answer.
But her account had $14k worth of losses!
I told her to sell everything immediately ―it would be an expensive learning lesson.
If you don’t know what you’re doing, leverage can wipe out your money…plus more. Frankly, most people don’t understand leverage and trade too big.
Don’t be scared.
I’ll explain how you can use leverage to your advantage throughout this lesson. Leverage is a powerful thing that can greatly increase your profits, if you use it correctly.
What is free margin in forex: Trading using margin correctly
When you want to buy or sell currency in forex, your broker will ask for some money upfront for each trade. That’s called ‘initial margin’. The initial margin comes out of your opening account balance (equity), such as the $5k in the above example. The margin depends on the size of your trades, as well as how much leverage you control.
Margin goes together with leverage.
If you have higher leverage (i.e. 100x instead of 50x, which was used in the previous example), your margin will be smaller. That’s because, when you have higher leverage you will have a higher total exposure and more free margin. So, the amount that you have to put down as the initial margin is lower, which keeps your forex free margin balance elevated.
If you’re confused, don’t worry.
We’ll explain it more below.
The takeaway for now is, while leverage is dangerous in the wrong hands, I believe you should get as much leverage as you can get your hands on – even though I said 10x is enough and 50x leverage is ideal. The higher amount of leverage will reduce your ‘initial margin’, which means you can take on more trades because you will have more ‘free margin’ in your forex account. For example, say you want to open a trade with a 50:1 leverage account. You will need to put up $1 for every $50 in your account. So if you want to trade a forex account of $250k, you will have to put down $5k of your own money at a minimum.
Pause for a tic…
Assuming you ONLY want risk $5k to learn forex trading and plan to a buy a $50k position on USD/EUR (i.e. an extremely high and dangerous move), that’s a fifth of your total exposure ($250k) assuming 50x leverage. In this case, similarly, you would have to put up a fifth of your own money in ‘initial margin’ to trade the position (i.e. $1k). (Maths = $5k x 20% = $1k).
That’s how ‘margin’ works.
The bigger the trade, the more margin needed.
When closing your trade, your broker will return the initial margin...plus/less the profit/loss from the trade.
When the forex trade is live, your forex broker will hold the margin as security for your trade. You can’t use it for other trades when the margin’s held, which is why your forex free margin will reduce. If you have a $5k account with a margin of $1k in trades, you can only trade with the other $4k. This, in other words, is your ‘free margin’. Put differently, using the above example, you have $200k of your total exposure left to play with if you’re trading a 50x leverage account.
What is free margin in forex: Real world example
The above example of forex margin and leverage is straightforward. To clarify, thanks to forex leverage, you can lose MORE than what you deposited into your forex account. In the real world, to reduce the risk of this happening, your broker will tell you how much margin you must keep in your account at all times, which we will explain more below. First, let’s discuss forex initial margin and forex free margin using a real world example.
In the picture above, the margin is AU$330 to place a €100k trade on EUR/USD (the picture is using a leverage ratio of 200x). Remember, I’m Australian and I trade with Aussie dollars (local currency). If you’re from a different country, your margin will show in your local currency and depend on the local forex leverage restrictions and broker rules. Using my example for now, the account balance has to be above AU$330 to place a trade.
If you can’t pay the ‘initial margin’ from the ‘free margin’ in your account, the forex trade will get rejected.
Forex trading example…
Let’s say you want to start trading with $5k in your account (i.e. equity). You also want to open two forex trades, and the broker requires a margin of $750 to open the trades. In this scenario, the margin level is ($5k / $750) x 100% = 667%.
But, in this case, the higher the margin level = the more free cash (i.e. forex free margin) you have available for other forex trading opportunities in your account. Most brokers will tell you how much cash you will have available. You can see this by looking at ‘free margin’, as shown in this example (fourth column from the left):
When your free margin falls to zero or below, no other trades can be made in forex. Similarly, when the margin percentage falls to 100%, you can’t place any other trades and you might get a margin call. If your margin level drops below 100%, it means that amount of money in your account can’t cover the your margin requirement. That puts you at risk of getting a margin call in forex.
What is a margin call in forex?
Many traders fear margin calls and often ask, what is margin call in forex? How can you avoid a margin call in forex?
If you trade wisely, there’s no need to fear them!
But what is a margin call in forex?
A margin call is when your account balance doesn’t have enough money to meet the margin requirement. Since forex prices move around, your free margin will constantly change, as we mentioned at the start of the lesson. If your forex trades start losing money, your free margin and margin level will fall. Your forex free margin can fall into negative territory, meaning your equity is below your margin:
With some forex brokers, if your margin percentage falls below 100%, they will immediately liquidate your positions so that you can meet your margin. That’s called a margin call. Keep in mind that all forex brokers are different. Most forex brokers will send you an email, telling you to top up your account with more money or they will liquidate your positions. Some forex brokers even let your margin percentage fall to 50% (smart stop) before stopping you out.
Pay close attention to your forex margin…
In my friend’s case, her broker didn’t even give her a margin call, even though she was down $14k. If she wasn’t paying attention, she might have woken up to an $200k loss the next day (you read horror stories like this all the time). My friend eventually sold her position and had to top up her account by $9k. That’s her total loss ($14k) minus the initial deposit ($5k).
Remember, margin calls ONLY come when you make trades too big for your account. My friend was shorting too many standard lots (see below) of dollar yen. If she had told me about her interest in forex, I would have told her to trade micros or minis at the start (see below).
If you trade smart, you won’t experience a margin call in forex ― especially if you use low leverage!
What is a lot in forex?
A lot refers to the amount of currency you are trading.
The trader enters the number of suitable lots. This is instead of buying huge amounts of currency pairs. The three main lot amounts are the standard lot at 100,000, mini lot at 10,000 and micro lot at 1,000.
This means every trader can adjust their risk.
Beginner and unprofitable forex traders should trade micro or mini lots. Experienced forex traders prefer to trade mini or standard lots.
What is a pip in forex?
The smallest increment of a pair is known as a pip.
Currency pairs are usually quoted in four or five decimals. Pairs containing JPY are quoted in two or three decimals. The pip is quoted on the fourth decimal or second decimal (JPY pairs).
We think in pips in the forex world, such as risk and reward.
In the above example, when trading the EUR/USD, each pip is worth AU$14.59 trading a €100k lot. If the EUR/USD rate changes from 1.2000 to 1.2001, the 0.0001 represents a change in price by one pip. Of course, if you trade less/more lots, your pip value will drop/rise.
How to calculate pip value in forex
The pip value lets us change ‘pips’ into dollars. This helps us understand how the number of pips represent the amount of profits or losses. It allows us to understand forex risks. The number of lots is represented by specific volumes of transactions. Combined with pips, this determines the pip value.
The pip value is not only a function of a pair. It depends on the number of pips the pair has moved, as well as your transaction volume. If you trade with a greater number of lots, your pip value will be higher. If you enter a lower number of lots, it will be lower.
Understanding how to calculate the pip value is important. It lets you know how much money you will earn or lose. Every currency has its own value, so the pip value is different. When the currency is the second in a pair, the pip value is the same, regardless of currency.
When you have a EUR base account, pairs with XXX/EUR, such as the USD/EUR, will have the same pip value. Therefore, a standard lot would be worth €10, a mini lot €1, and a micro lot €0.10.
This method works even with a different base currency. If you’re just starting, you should resist the urge to trade big. Start trading micro lots (which are only a couple of cents) to gain confidence, skill and experience.
Your ‘Start With Forex’ takeaway: What is Free Margin in Forex?
The forex is the largest market in the world.
Most trades are done by only a few players on a few major currencies. When I first started trading forex, I would sit at my screen all the time.
I can’t get back that time.
Don’t be at your desk each hour of every waking day, trading.
Forex isn’t a life ― it’s a business.
Pick you battles.
Now that you understand what is free margin in forex. You should use your ‘free margin’ and time wisely!
Your ‘Start With Forex’ top tip: Choose the most active sessions and currencies to trade forex. You don’t need to trade every currency. Get familiar with one or two major currencies and look for repeating patterns, trade breaking news, or wait for setups to come to you. If you treat forex as your business, you will only take forex trades that make sense to you. If your trading forex wisely, you will control leverage and have lots of ‘fire power’ (i.e. cash) in your free margin. Most importantly, because you will have lots of ‘fire power’ in your free margin, you won’t get a margin call!
That’s the secret of forex trading.
Manage your capital wisely and look after yourself. Don’t forget, if you run out of capital, you’re forex trading business in finished!
If you’re ready to learn about the most profitable forex pairs, click here.
To your trading success,
Start With Forex
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Lesson Six: The Relationship Between Margin and Leverage