Basics of Forex Trading You Must Need to Know

Leverage, Margin, Balance, Equity, Free Margin, Margin Call And Stop Out Level In Forex Trading

I always see that so many traders who trade forex, don’t know what margin, leverage, balance, equity, free margin and margin level are, and so, they don’t know how to calculate the size of the position they want to take based on the risk and the stop loss size.

Margin and leverage are two important terms that are usually hard for the forex traders to understand. It is very important to understand the meaning and the importance of margin, the way it is calculated, and the role of leverage in margin.

Leverage:

Leverage is a feature offered by the broker, to help the traders to trade larger amounts of securities by having a smaller account balance. For example, when your account leverage is 100:1, you can buy $100 by paying $1. Therefore, to buy $100,000 (one lot), you should pay only $1000. This was just an example. I know nobody pays dollar to buy dollar

Now you tell me please. How much you have to pay to buy 10 lots USD through an account that its leverage is 50:1 ?

That is right. You have to pay $20,000 to buy 10 lots or $1,000,000 USD:

$1,000,000 / 50 = $20,000

Leverage was so easy to understand, right? I had to explain it first, to become able to talk about the other term which is margin.

Margin:

Margin is calculated based on the leverage, but to understand the margin, let’s forget about the leverage for now and assume that your account is not leveraged or its leverage is 1:1

Margin is the amount of the money that gets involved in a position or trade. Let’s say you have a $10,000 account and you want to buy €1,000 against USD. How much US dollars do you have to pay to buy €1,000?

Let’s assume that EUR/USD rate is 1.4314. It means each Euro equals $1.4314. Therefore, to buy €1,000, you have to pay $1,431.40:

€1,000 = 1000 x $1.4314

Therefore:

€1,000 = $1,431.4

If you take a 1000 EUR/USD long position (you buy €1000 against USD), $1,431.4 from your $10,000 account has to be locked in this position. When you set the volume to 0.01 lot (1000 unit) and then you click on the buy button, $1,431.4 from your account will be paid to buy 1000 Euro against USD.

This “locked money” which is $1,431.4 in this example, is called margin. Now, if you close your EUR/USD position, this $1,431.4 will be released and will be back to your account balance.

Now let’s assume that your account has a 100:1 leverage. To buy 1000 Euro against USD, you have to pay 1/100 or 0.01 of the money that you had to pay when your account was not leveraged. Therefore, to buy 1000 Euro against USD, you have to pay $14.31:

$1,431.4 / 100 = $14.31

Now, please tell me that if you take a one lot EUR/USD position with an account with the leverage of 100:1, how much margin will be locked in this trade?

One lot EUR/USD = 100,000 Euro against USD
EUR/USD rate: 1.4314
100,000 x 1.4314 = 143,140.00
Therefore:
One lot EUR =$143,140.00

Leverage: 100:1

Margin = $143,140.00 / 100 = $1,431.40

Therefore, to have a one lot EUR/USD position with a 100:1 account, a $1,431.40 margin is needed, while the EUR/USD rate is 1.4314. This needed $1,431.40 margin is called “required margin”.

Balance:

When you have no open positions, balance is the amount of the money you have in your account. For example, when you have a $5000 account and you have no open positions, your account balance is $5000.

Equity:

Equity is your account balance plus the floating profit/loss of your open positions:

Equity = Balance + Floating Profit/Loss

When you have no open position, and so no floating profit/loss, then your account equity and balance are the same.

When you have some open positions and for example they are $1,500 in profit in total, then your account equity is your account balance plus $1,500. If your positions were $1,500 in loss, then your account equity would be your account balance minus $1,500.

Free Margin:

Free margin is the difference of your account equity and the open positions’ required margin:

Free Margin = Equity – Required Margin

When you have no positions, no money from your account is used as the margin. Therefore, all the money you have in your account is free. As long as you have no positions, your account equity and free margin are the same as your account balance.

Let’s say you have a $10,000 account and you have some open positions with the total required margin of $900 and your positions are $400 in profit. Therefore:

Equity = $10,000 + $400 = $10,400

Free Margin = $10,400 – $900 = $9,500

Margin Level:

Margin level is the ratio of equity to margin:

Margin Level = (Equity / Margin) x 100

Margin level is very important. Brokers use it to determine whether the traders can take any new positions or not. Different brokers have different limits for the margin level, but this limit is usually 100% with most of the brokers. This limit is called Margin Call Level.

100% margin call level means if your account margin level reaches 100%, you can still close your open positions, but you cannot take any new positions. Indeed, 100% margin call level happens when your account equity equals the margin. It happens when you have losing position(s) and the market keeps on going against you and when your account equity equals the margin, you will not be able to take any new positions anymore.

Let’s say you have a $10,000 account and you have a losing position with a $1000 required margin. If your position goes against you and it goes to a -$9000 loss, then the equity will be $1000 ($10,000 – $9,000), which equals the required margin. Therefore, the margin level will be 100%. If the margin level reaches 100%, you will not be able to take any new positions, unless the market turns around and your equity becomes greater than the required margin.

But what if the market keeps on going against you?

If the market keeps on going against you, the broker will have to close your losing positions. Different brokers have different limits and policies for this too. This limit is called Stop Out Level. For example, when the stop out level is set to 5% by a broker, the system starts closing your losing positions automatically if your margin level reaches 5%. It starts closing from the biggest losing position first.

Usually, closing one losing position will take the margin level higher than 5%, because it will release the required margin of that position, and so, the total used margin will go lower and therefore the margin level will go higher. The broker’s system takes the margin level higher than 5% by closing the biggest losing position first. However, if your other losing positions keep on losing and the margin level reaches 5% again, the system will close another losing position.

Why the broker closes your positions when the margin level reaches the Stop Out Level?

The reason is that the broker can not allow you to lose more than the money you have deposited in your account. The market can keep on going against you forever and you lose all the money you have in your account and then get a negative balance if nobody closes your losing positions. If you don’t pay the negative balance, the broker has to pay it to the liquidity provider (of course if the broker is a true ECN/STP broker).

As it is almost impossible to take the loss from the trader, brokers close the losing positions when the margin level reaches the Stop Out Level.

How to Check Your Account Balance, Equity, Margin and Margin Level?

You can see all of these parameters by checking the MT4 terminal. Open the MT4 and press Ctrl+T. The terminal will be opened and it shows your account balance, equity, margin, free margin and margin level.

This is how the terminal looks when you have no open position:

And this is how it looks when having an open position:

This can be different in other platforms.

Balance will change only when you close the position. The profit/loss will be added/deducted to the initial balance and the new balance will be displayed.

Balance – Floating Profit/Loss = Equity
$10,000 – $50 = $10,050

Margin = $2,859.52
(200,000 x 1.4300) / 100 = $2,860.00

Equity – Margin = Free Margin
$10,050 – $2,859.52 = $7,190.48

(Equity / Margin) x 100 = Margin Level
($10,050 / $2,859.52) x 100 = 351.46%

OK!

I hope you are not confused. It is very easy to understand. You may need to read the above explanations for a few times to completely digest the terms I explained.

 

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