2024.04.30
2023.05.29 What is the Difference Between Margin and Free Margin in Forex?
Artem Parshinhttps://www.litefinance.org/blog/authors/artem-parshin/
Everyone who opened a trading account with a broker has come across the term margin. Depending on the type of market, the name may vary. In Forex, such concepts as free margin and equity are mainly used. In the stock market, they are referred to as balance and collateral.
However, the names are not so important. Regardless of the financial market, everyone needs to study these concepts since the result of trading largely depends on margin levels.
The article covers the following subjects:
- What is margin trading?
- How to calculate margin
- What is free margin?
- How to calculate free margin
- Margin levels
- Conclusion
- Free Margin in Forex FAQ
What is margin trading?
Margin in trading is the share of funds in the trader's account that provides guarantees for an open transaction or transactions. In other words, the forex margin is the part of the funds required to open trades. If the used margin exceeds the size of the deposit, the broker will not allow you to open it.
The margin value determines the maximum leverage that can be used for trading. Therefore, trading with leverage is called margin trading.
The forex broker primarily needs the margin as a guarantee that traders have their own funds to pay for the transaction. The lower the leverage, the higher the required Forex margin, and vice versa. In markets where trading is carried out with minimum leverage, margin requirements are usually determined by the deposit size.
How to calculate margin
Forex margin is part of the total funds in the account. It is calculated using the following formula:
(Volume (lot) × Contract size (currency unit) × Quote) / Leverage
For example, you decide to buy one lot of the EURUSD. The current exchange price is 1.1030, and the leverage provided by the forex broker is 1:100. In this case, the formula will look like this:
Margin = (1 × 100,000 × 1.1030) / 100 = 1,103 USD
Thus, to enter a trade with this lot, you must have at least 1,103 USD in your account.
If there are insufficient funds in the account, you can solve the problem by increasing the leverage or reducing the trade volume. Let's increase the leverage to 1:500.
Margin = (1 × 100,000 × 1.1030) / 500 = 220 USD
The amount of the required collateral decreased by five times. As the trading volume decreases, margin requirements will decrease similarly.
What is free margin?
The concept of free margin is inseparable from the concept of margin. Free margin is the amount of funds in a margin account that is not involved in transactions and can be used for trading or withdrawal. In other words, Forex free margin is an indicator of the amount of money in the account that can be used to open additional trades. If there are no open trades on the account, Forex's free margin equals the balance and equity.
Free margin is an important indicator. Experienced traders spend it only when absolutely necessary. If the free margin in the Forex market approaches 0, the trading account is in a dangerous position. In this case, brokers may use a margin call to prevent losses.
How to calculate free margin
Free margin is part of the funds remaining on the account after opening trades. It is calculated by the formula:
Free Margin = Funds (Equity) - Margin
Let's calculate the free margin when buying one lot of EURUSD. Let's say the trading account balance is 5,000 USD. The current exchange price of the asset is 1.1030, and the leverage provided by the broker is 1:100. Thus, the formula will look like this:
Free Margin = 5,000 - 1,103 = 3,897 USD
This example shows how to calculate free margin without considering open trades and other charges on the trading account. To get a more accurate value, you need information on open trades.
For example, before opening trade, you already have another open trading position, which brings a profit of 100 USD. In this case, the equity indicator will not be equal to the balance of the trading account. Therefore, first of all, it is necessary to calculate the equity:
Funds (Equity) = Balance + Profit (or Balance) - Loss
Funds (equity) = 5,000 + 100 = 5,100 USD
Free Margin = 5,100 - 1,103 = 3,997 USD
Free margin example
Let's find out where the margin and free margin parameters are displayed when trading in Forex using the real trade example.
1 – Assets total or Funds;
2 – Assets used or Forex margin;
3 – Available for operations or Free Margin.
I opened a one lot EURUSD trade (see the screenshot above). Since the leverage is 1:200, the required collateral or Forex margin is 552.37 USD. Since the trade is open and there is a margin used, it means that there is also a free margin. This is the third indicator, which is equal to 3,888.16 - 552.37 = 3,335.80 USD.
Margin levels
In addition to the two main indicators, margin and free margin, there is an additional indicator of the margin level. This is the ratio of account funds to the margin, expressed as a percentage.
In other words, the margin level is the ratio of equity to deposit utilization. It is also called the maximum deposit load. The margin level shows how much the trading account is loaded with open trades.
Let's take the parameters of the transaction and the trading account from the previous example:
Margin Level = (Equity (Equity) / Margin) × 100%
Margin Level = (3,888.16 / 552.37) × 100% = 703.904%
According to this calculation, we can conclude that the trading account is not much loaded, and several more trades can be opened. However, if you lose money quickly, the rate will decrease. The moment when it reaches 100% will mean that the funds are equal to the margin. Then you will not be able to open new trades, and soon you will get a margin call. To avoid this, do not forget to use a stop loss.
Margin calls and Stop Out
Margin call was mentioned several times in the article. Let's figure out what it is. In addition to a margin call, there is a stop-out level. Since beginners often confuse them, let's talk about their differences.
A margin call is a signal to the broker that the trader's trading account is overloaded and the forex margin has reached a critical value. If you do not add free funds to your trading account, opened trades will be closed forcibly.
Stop out is used to force brokers to close trades (starting with the most unprofitable one) when the margin reaches a certain level. When this operation is completed, closed trades release the margin. If the indicator returns above the threshold value, the closing of trades will be completed.
Each broker has its own margin call and stop-out levels. Traders must understand that brokers risk their own funds by providing leverage. If they do not limit losses in time, they may suffer losses. To avoid reaching these levels, leave more free margin in your account.
Conclusion
Successful traders must clearly understand the differences between margin, free margin, and equity. The result of trading largely depends on this.
The margin in Forex trading is the main risk indicator. The higher the margin, the less room for maneuvering in the event of an emergency.
Free margin is an indicator of trading account maneuverability. The more free funds, the higher the chances that everything can be fixed in a critical situation.
Funds or equity is an indicator of the total amount of funds that are available in the account. When the trade is profitable, the equity increases, and, accordingly, the free Forex margin. In the event of a loss, the equity decreases, reducing the amount of free margin.
Free Margin in Forex FAQ
Forex margin depends on the number and volume of open trades. If there are few trades and they are opened with a small volume, the margin will be small. If there are a lot of trades open and they are opened with a large volume, the margin will be high, which can lead to the loss of the account.
A free margin is a reserve of free funds on the trading account. A free margin in the foreign exchange market directly depends on the funds in the account. If equity increases as a result of making a profit, a free margin will also increase. If the equity decreases, the free margin will also decrease.
If the free margin drops to zero, you will not be able to open new trades. Forex transactions have a value, that is, an amount of funds needed to open them. If the free margin is less than necessary to open a new trade, the broker will not allow it to be opened.
Free margin can only become negative if the margin of the traders’ open trades exceeds the equity. In other words, traders suffer losses, and the only thing they can do is close them, releasing margin. Otherwise, a stop-out situation will occur.
There are three ways to increase free margin. First, add new funds to your trading account. Second, close one or more trades. Thirdly, create counter positions for identical instruments, which are often called a lock.
The best leverage level is the one at which you are comfortable trading Forex. If you are willing to take risks and want a quick profit, leverage from 1:50 to 1:100 will suit you. If you are a conservative trader and are willing to wait longer for a profit, do not use leverage above 1:10.
The best margin level is one that will allow you to make a few more attempts if you fail. For conservative trading, the margin should not exceed 15% of the equity. When trading aggressively, the margin can range from 30% to 60% of the equity.
Forex margin is calculated as the ratio of trade volume to leverage. You just need to divide the value of the contract for a particular instrument by the leverage size.
Margin = (Trade Volume × Quote) / Leverage
The margin level for safe trading should always exceed 100%. If you don't want to risk, keep the margin level at least 700%. If you are willing to take risks for a bigger profit, choose a margin size from 300% to 400%.
To avoid a margin call triggering on your account, keep your margin level above 100%. In other words, make sure that there are always free funds. Also, don't let the margin get close to equity in size.
The content of this article reflects the author’s opinion and does not necessarily reflect the official position of LiteFinance. The material published on this page is provided for informational purposes only and should not be considered as the provision of investment advice for the purposes of Directive 2004/39/EC.
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