What is margin in trading and how does it work?

Margin is a term that traders use to describe the amount of money they have in their accounts. Margin is important because it impacts how much you can trade with and what type of margin call you may receive.

When you are 'buying on margin', it means you are using money borrowed from your broker to open a trade. To do this, you would need to open a margin trading account with your broker which is different from a normal trading account. 

If your margin falls below a certain point, then your broker will likely issue you a margin call - but more on that later.

Not all brokers use margin equally, so continue reading to make sure you understand how margin is used in trading, the pros of cons of margin trading, and the different types of margin available.

What is margin in trading?

The forex trading market is the largest financial market globally, with an estimated daily trading volume of $6.6 trillion. This makes it very attractive for anyone wanting to try and profit from it, however, before you jump in there are some critical concepts that new traders need to grasp. And one of the most important concepts you must understand is the margin.

Before being able to trade, a trader needs to put an initial sum of money (otherwise known as capital) into their trading account. Margin is a portion of your funds set aside from the account balance to keep positions open or to maintain them, which effectively acts as a deposit or collateral that is placed with a brokerage firm. Moreover, the amount of margin you need to have in order to trade varies between brokerage accounts.

Understanding margin is important because it’s directly associated with margin trading. Margin trading uses a portion of your own trading capital while borrowing the remaining amount from the broker so that you can trade different assets including forex, indices, commodities, and cryptocurrencies.

As a forex trader, utilising margin allows you to get access to more and larger opportunities when compared to only using your own capital. This makes margin trading one of the essential trading methods employed by traders, regardless of their experience, but also one of the riskier methods.

How does trading on margin work?

Trading using margin or 'buying on margin' is similar to a loan, where you are borrowing money from your broker in order to open a larger position than you would normally be able to. A regular cash account with your broker would not allow the ability to trade on margin, so a margin account is required from your brokerage.

There is usually a required initial investment needed in order to open a margin account which is known as minimum margin. The size of this initial deposit can vary per broker.

To be able to operate the margin account and buy on margin, the initial margin amount will have to be met too. This is a minimum balance requirement to have in your account to open a position. The initial margin rate will be different across the various instruments to trade, so make sure to pay attention to the product schedule to see the rate for the assets you wish to trade.

When a trade has been placed the margin loan will stay open as long as you like, making sure to fulfill all obligations you have such as paying interest on the margin. Once the trade has been closed, the money will go to your broker to complete the remaining amount of the borrowed funds.

Example of using margin in forex trading

Using an example in forex trading, an investor's account would need to deposit a certain amount based on the margin percentage required by the broker. To trade with 100,000 units or more, the margin percentage is usually 1%.

This means the trader would need to have $1,000 (1% margin) deposited into the account to be able to trade with $100,000. The remaining 99% of the amount is handled by the broker.

Example of using margin in cryptocurrency trading

Let's look at an example of buying on margin using a cryptocurrency CFD. If you were to open a long position on BTCUSD worth $1,000, you would not be required to pay the full amount.

The initial margin rate for BTCUSD is 20%, which would require you to have only $200 in your account to be able to open the position of $1,000.

What is a margin call?

A margin call is definitely one kind of “call” you don’t want to get. Once upon a time it actually was a phone call, but these days it’s an email alerting you that the available margin in your account is getting dangerously low.

A margin call happens when the account value falls below the broker's required minimum value. When this happens, the broker will require the trader to deposit additional funds into their account to balance the minimum maintenance margin, which varies from broker to broker.

What happens if I can't pay a margin call?

If a margin call is not met, it enters a stop-out level. The stop-out level is a specific level at which all active positions are closed by the broker because they can no longer be supported due to insufficient margin levels. The broker may close out any open positions to bring the account back up to the minimum value, without the trader’s approval. Do note that this process is usually not possible to stop as it is automated. The broker may also charge a commission on the transactions, with the trader being responsible for any losses sustained during this process.

This is a worst-case scenario and it typically stems from bad trading habits and common trading mistakes.

Regardless of your experience with trading, you can protect yourself to a degree by using money management strategies like a stop loss for any open positions – especially for scenarios when the market moves violently against you. Similarly, you should always ensure you have enough funds in your account and don't enter into trades that are too large relative to the amount in your account.

What is margin level?

Margin level is defined as the margin available to a trader to open more positions and is shown as a percentage, calculated using the ratio of equity to used margin:

Margin level = equity / margin * 100.

How to monitor margin levels?

Using the Market Watch view on the MT4 trading platform, it’s easy to monitor the available margin level in a trading account. Using this view, you can quickly track all the relevant information – such as account balance, free equity, and available margin – and use this to manage margin levels accordingly.

How to calculate margin requirements?

All brokers offer different minimum margin requirements, so it’s a good idea to check the margin requirements of the broker you are using or intend to use. After that, calculating the margin requirements is easy: all you need to do is multiply the number of trades you want to open by the margin. 

For example, let’s say you want to enter a $10,000 trade at a 3.5% margin. You multiply 10,000 X 0.035 = $350. This means you need to have $350 (at a minimum) in your account to open the trade.

Leverage

When you use margin, you are given leverage for your trading, which goes together with margin trading; you’ll see this expressed as a ratio like 20:1, 50:1, or 100:1 depending on the jurisdiction you are trading in.

Let’s look at an example to see how it works.

Suppose a trader has $1,000 in their account but feels that’s not enough to trade with. They might then opt to use the leverage provided by a broker. If they chose to use 10:1 leverage, their investment potential would turn into $10,000 (1,000 X 10). The broker will take a certain amount as a margin - which varies between the different financial instruments - and essentially lend you the rest to enable you to open the position.

The benefit of leverage is that it gives traders the ability to enter and control larger funds using a small margin. This is appealing to many traders, but it is important to remember that margin trading and leverage can be a double-edged sword as they can magnify both wins and losses.

How much leverage to use?

One of the mistakes new traders make is to use a high level of leverage, thinking they will make huge profits very quickly. While this is a possibility, the opposite scenario can also happen. If the market turns against your trade, it’s possible to suffer big losses and, in some cases, accounts have been wiped out (closed out) due to the use of high leverage.

To counter this, it’s advisable for beginner-level traders to use a smaller leverage ratio until they get familiar with trading, and gain more confidence in their ability. This serves as a risk management strategy, which provides more room to trade without risking too much of your capital.

Use this table to understand and calculate margin requirements and levels of leverage:

What is the difference between margin and leverage?

An investor will use a margin in order to create leverage. When using leverage, it gives you the ability to open larger positions when using a margin account. 

Leverage is always shown as a ratio, while margin requirement will generally be expressed as a percentage.

For example, if you wanted to trade a mini lot of AUD/USD without using any margin, the amount of money needed in your account would be $10,000. If the margin requirement for this currency pair is only 1%, then in your account you would only need to deposit $100. The broker would be providing a leverage ratio of 100:1 for this trade.

What are the different types of margin?

There are a few margin terms you need to get acquainted with if you are going to explore margin trading.

• Initial margin: The initial margin is the minimum amount you need to have in your account in order to open a position.
• Variation margin: Variation margin is based on the current value of all open positions.
• Maintenance margin: Maintenance margin is the minimum amount required to maintain your margin account after opening a position.
• Free margin: Free margin can be classified in two ways: the available amount of margin to open new positions and the amount available from current positions that can move against you before there is a margin call received.

Pros and cons of margin trading

It is no secret that margin trading is a very popular investment option for traders around the world, with the opportunity to open positions of a larger volume. But with this opportunity comes many potential risks.

Discover the pros and cons of margin trading below:

Pros

• Maximising potential returns with greater leverage
• Increased number of trading opportunities
• Ability to use more advanced trading strategies
• The interest on your borrowed money can be tax deductible from your net investment income

Cons

• The ability to open larger positions means the losses can be bigger
• Additional costs (interest) required to pay to the broker
• Chance to lose more money than you initially invested
• Increased risk when margin trading

What to bear in mind before trading with margin?

Seasoned margin investors have been using margin trading for years and through their many trades have been able to find success by following some common tips.

• Utilise margin for the right instruments: You need to be aware of your investment goals and decide if using margin for certain instruments is appropriate. Using a margin account with long-term growth in mind would be a better outcome than using margin for retirement finances or funding certain things like child education fees or mortgage repayments.
• Be selective: Like all investments, proper due diligence should be taken before buying a new asset. This is especially important when buying on margin. Consider instruments that have strong fundamentals and demonstrate long-term growth. Don't follow the herd and jump on the next big stock or cryptocurrency that's trending.
• Test on a small scale: What better way to understand and be successful using margin than to start off by using it? Start investing on margin to experience the risks and costs involved but begin by investing on a small scale first.
• Shorter periods of time: Consider sticking to shorter time windows e.g. one or two months for margin purchases. This way you are not exposed to long periods where a market correction could occur or an unforeseen drop in price. You must remember too, that you are paying interest on the margin since they are borrowed funds, meaning your net investment return will be smaller.
• Try to avoid margin calls: Try to avoid this situation as it could mean you sell off an important asset, potentially missing a rally or locking in losses.
• Don't get greedy: Always remember to set a target price and don't get greedy even if the asset has gone on a good run. This can be said for both winning and losing sides, make sure to set a limit for how many losses you are going to take too. This is one of the common trading mistakes many investors make, holding on too long.

What are the risks involved in margin trading?

By now you understand that margin trading carries with it some pretty significant risk. Margin accounts are not available to everyone but if you do eventually want to start exploring this as an option in your trading, then consider some of the risks involved with buying on margin:

• ​Margin call
• Amplified losses
• Liquidation

Conclusion

When used properly, and as part of the overall risk management strategy, margin trading can be a very effective tool in your trading kit. It helps manage and optimise trading capital and lets you take advantage of multiple trading opportunities – and the same is true with leverage. Just remember that both margin trading and leverage can magnify wins and losses, so use them responsibly!

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This information is not to be construed as a recommendation; or an offer to buy or sell; or the solicitation of an offer to buy or sell any security, financial product, or instrument; or to participate in any trading strategy. It has been prepared without taking your objectives, financial situation, or needs into account. Any references to past performance and forecasts are not reliable indicators of future results. Axi makes no representation and assumes no liability regarding the accuracy and completeness of the content in this publication. Readers should seek their own advice.