Pretend for a moment that a home in a desirable neighborhood just came onto the housing market, and you would like to purchase it for your family. It is listed at $200,000. You can't afford to write out a check for that much money, but you know that doesn't mean you can't afford to purchase the home. You visit your bank and receive a pre-approval to finance a home up to $200,000 with the agreement that you will pay a 5% down payment.
That pre-approval gives you permission to enter into a purchase contract with the current owners of the home even though you can't fully fund the purchase at this time. When learning forex, this is the basic concept behind Forex margin and leverage trading. This page is dedicated to a comprehensive understanding of the term "margin," but you will also see some references to the term "leverage." These terms work together, so make sure you understand them both fully.
When you open a Forex trading account that allows leveraged trades, you have the ability to open market positions worth more than the actual value of your account. This is similar to the bank allowing you to finance that $200,000 home even though you don't have $200,000 upfront.
The difference is that you don't have to make payments as you would with a mortgage loan because you aren't actually borrowing money. Your broker doesn't have to pay money out when you enter a position on the market because you are promising to buy or sell a currency at a given rate without making that purchase immediately. You will never owe any money unless you close a leveraged trade with a loss.
The possibility that you could take a loss on a leveraged trade is the reason brokers require you to maintain a margin balance in your account. They need to know that you have the means to cover at least part of the loss if it occurs. Think of it as your broker's security fee that you only lose if you make a bad trade.
You don't have to meet your margin account balance through cash funds alone. Brokers determine the total equity of your trading account, allowing you to apply profit from open market positions toward your margin balance. Equity simply refers to the complete value of your account. Just as your personal financial worth may include investments beyond the cash you have in your bank account, your Forex account equity goes beyond cash on hand.
A simple Forex calculation formula is used to determine the equity of a trading account:
Cash Balance + Profit from Open Positions – Loss from Open Positions = Equity
Cash funded into your account is added to the total profit showing from your open positions, and then any loss showing from your open positions is subtracted from that total. Profits and losses are determined based on the value of your open positions if you were to close them at any given moment, so your equity will fluctuate as currency prices change.
The margin balance required for your account is determined by the amount of leverage authorized for the account. It is reflected as a percentage of the total amount of money you are authorized to invest at any given time, including the leverage.
A simple Forex margin calculation formula is used to determine the margin for an account:
1/Leverage = Margin
This simply means that you divide 1 by the amount of leverage allowed to determine the margin percentage that must remain in your account at all times.
In the United States, traders are limited to a 50:1 leverage ratio. This means that for every dollar funded into a trading account, American traders can invest $50 on the market. $49 of that investment is leveraged. When 1 is divided by 50, you get 0.02. This translates to a 2% margin required on all American trading accounts.
The amount of leverage offered on accounts managed outside of the U.S. can vary, with some going as high as 400:1. This allows for larger trades which can bring in substantial profits, but it also exposes you to greater losses and increases the amount of equity that you must maintain in your account.
Once you understand your leverage ratio and margin percentage, you can calculate Forex margin requirements for specific trades. The following steps will walk you through the process:
From that calculation, you can look at the amount of equity on your account to see if you can afford to make that trade.
You never want to use the full amount of margin available on your account because market fluctuations could push your account below the required margin balance at any time. In that case, your broker would close your least profitable open positions until your account complies with the margin balance.