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It is hard to learn the whole concept of margin trading without getting familiarized with its jargon.
Don't worry; this lesson is your ready-to-go cheat sheet about margin trading. I have here all the margin terminologies you need to know to confidently navigate the market on margin.
Your trading account's balance is the total amount of money you've deposited to your broker.
When you have an open position, your account balance will remain the same before you open a position. It will only be affected once you close the position.
Here are the only three factors that move your account balance:
The equity of your trading account is simply your account balance. However, unlike the account balance, your equity moves with your open positions.
That is because the equity is your account's "real-time value." Your equity realizes the floating profits and losses of your open positions.
Here's the formula to calculate your account equity:
Equity= Account Balance + Floating Profit/Floating Loss
Assume you enter a position with an equity of USD 5,000. Now, your position has a floating loss of USD 100. With that, your current account value or equity is USD 4,900.
Equity= USD 5,000 + (USD -100)
Equity= USD 4,900
Your broker technically allows you to access a much larger position than your deposit or collateral when trading on margin.
Your margin is the deposit or collateral you must put in your trading account to open and maintain a leveraged position. A margin ensures you can support your leveraged position when it experiences losses.
If you're a beginner trader, you might be confused about the margin and the required margin. Just remember your actual margin can be higher than the required margin.
You can put a margin or a deposit of USD 5,000 and use USD 1,000 for a position's required margin.
When margin trading, your broker gives you buying power or capability to open a position with a smaller capital. That is by providing you with leverage.
Essentially, leverage is a loan your broker gives you to control a larger position than what you have in your account. You use leverage to magnify your margin (the amount you need to open a specific position) and gain potentially larger returns with your leveraged position.
However, remember that leveraging your trade also subjects you to significant risk. You must never forget the risk associated with margin trading.
Note: Leverage is expressed as a ratio, such as 20:1, 50:1, and 100:1. It's the ratio between the amount you can trade and the amount you have.
Your account equity moves with open positions while riding the market's movement. Technically, it always changes value because your open positions have unrealized profits or losses, also known as floating profits/losses (P/L).
When calculating your unrealized P/L, the profits must be expressed as a positive value (USD 50), while unrealized profit is expressed as negative (USD -50)
Remember, your floating profits or losses are the sum of all the open positions in your account. If one of your positions happens to have unrealized losses while the rest have unrealized profits, you simply add and subtract the values.
Unrealized P/L= Position A Profit + Position B Profit + Position C Loss
Assume you have three open positions: long EUR/USD, GBP/USD, and USD/CHF. Both EUR/USD and USD/CHF have unrealized profits of USD 100 and USD 65, respectively. Meanwhile, your GBP/USD position has USD 80 in unrealized loss.
Unrealized P/L= USD 100 profit + USD 65 profit + (USD -80 loss)
Unrealized P/L= USD 165 profit + ( - USD 80 loss) or USD 165 profit - USD 80 loss
Unrealized P/L= USD 85 profit
Your position's margin requirement represents the amount of margin you need to open a position. It's expressed as a percentage of the total position worth or the notion value.
Margin requirements vary depending on your broker, and each broker has a different margin requirement for various pairs.
Here are the common margin requirements for different majors:
Unlike margin requirement, your position's required margin is expressed as the money you need for the specific position. It's the value of the margin requirement, which is the percentage of the notional value.
Assume you have a margin requirement of 2% for EUR/USD with a notional value of USD 120,000.
To get the required margin value, you must simply get the 2% of USD 120,000.
Required Margin= Notional Value * Margin Requirement
Required Margin= USD 120,000 * 0.02
Required Margin= USD 2,400
When trading on margin, you should "tie up" your required margin to your trading account. You should maintain this minimum amount to ensure you can support your leveraged position.
Note: If your pair's base currency is different from your account's currency, you can use this formula:
Required Margin: Notional Value * Margin Requirement * Base and Account Currency's Exchange Rate.
Your trading account's used margin is the portion of your equity that must be locked into your account. To keep your positions open, you must maintain your equity above the used margin level.
If you only have one open position, your used margin is the same as your required margin. However, if you have two or more positions, simply get the sum of all the required margins.
Used Margin= Position A required margin + Position B required margin + Position C required margin
Assume your positions have a required margin of USD 1,000, USD 2,400, and USD 200. Then, your used margin is USD 3,400.
Used Margin= USD 1,000 + USD 2,400 + USD 200
Used Margin= USD 3,400
Note: Used margin is essential in determining the health of your margin level.
Contrary to used margin, free margin is the amount of money in your equity that you can use to open another trade.
Essentially, free margin is viewed as a supporting cushion for your open position. If the unrealized losses consume most of your equity, the free margin acts as a buffer to absorb potential losses from the open positions.
To calculate the value of your free margin, subtract your account equity from the used margin.
Free Margin= Account Equity - Used Margin
Your account's margin level determines the health of your margin trading. Knowing your account's margin level gives you a real-time risk-exposure assessment of your positions.
The higher your margin level, the bigger your position's safety cushion. A high margin level informs your broker that you have sufficient free margin to open and support additional positions.
To calculate your margin level, you simply find the ratio between the equity and used margin and get the percentage of the value.
Margin Level= (Equity/Used Margin) * 100%
Say you have an equity of USD 4,000, an account balance of $4,500, and a floating loss of USD 500. Additionally, you have open positions that have used margins of USD 2,240.
Margin Level= (USD 4,000 / USD 2,240) * 100%
Margin Level= 1.7857 * 100%
Margin Level= 179%
Remember, accounts with over 150% margin level still have enough safety cushion for your open positions. However, opening and supporting additional positions will be harder without depositing more money into your account.
When your margin level reaches the margin call level, it can only mean two things:
When you're in a margin call level, it only means your position is on a constant losing streak. This means you can't open any more positions because your margin level can't support them.
Note: A margin call is just a warning. Receiving a warning call does not necessarily mean your position will be liquidated.
When trading on margin, the worst possible scenario you'll ever imagine is the stop-out. Your broker will liquidate your open positions to get your margin above the stop-out level.
The stop-out level depends on your broker. When your equity reaches this level, your broker will close your positions individually. This process starts from the least profitable position and works until it liquidates all your positions or brings your margin level back above the margin call threshold, whichever comes first.
Congratulations!
You're now well-equipped with the jargon and terminologies about margin trading. In the next lesson, you'll explore five best practices for avoiding margin calls.