The previous lesson was a refresher about margin calls and why you wouldn’t want to receive one from your broker.
Virtually all traders dread receiving margin call notifications, and what can potentially follow suit—stop-out orders—is feared even more.
This is why caution is the name of the game whenever you are trading on margin.
In this lesson, you will recall why margin trading, in general, should always be done carefully and with great planning.
Lesson Highlights
- Trading on margin lets you control positions much larger than your current balance.
- To calculate the required margin, multiply your position’s notional value by the margin requirement set by your broker.
- Margin calls are broker-initiated notifications when your account’s margin level reaches or falls below the margin call level.
- Margin trading can net you larger gains, but also exposes you to equally bigger risks.
What Is Margin Trading
As you’ve learned in your past lessons, you can view margin as some sort of collateral you give to your broker when you open margin positions.
The portion of your trading account balance that brokers set aside as a margin requirement reflects the amount of leverage or buying power they give you in return.
Suppose you want to open a long position in the EUR/USD pair worth 10,000 at the current exchange rate of 1.3500. Your broker offers a 2% margin requirement for opening a leveraged position in this currency pair.
A 2% margin requirement implies that your broker offers a 50:1 leverage. This means that to open a position of one mini lot (10,000 units) in the EUR/USD pair, you need at least USD 270 in your trading account.
Calculating the Required Margin
The computations below show why you need a minimum of USD 270 for the required margin.
Required Margin = Margin Requirement * Notional Value
To get the notional value, multiply the position size (10,000) by the current exchange rate (1.3500).
10,000 * 1.35 = 13,500
Once you have the notional value, multiply it by the margin requirement (2%) to get the required margin or the amount you need to have in your trading account.
13,5000 * 0.02 = 270
This means you can effectively control a position 50 times larger than your current balance (if you only have USD 270 in your account).
Beware, however, that once you open a margin position, you also open yourself to the possibility of margin calls.
Margin Calls Again
Margin calls are notifications from your broker that your account’s margin level has reached or fallen below the margin call limit.
As you already know, brokers typically set margin call levels at 100%. Once the margin level of your account reaches or dips below this threshold, your broker will contact you.
Generally, you have three options when you receive a margin call. You can deposit more funds into your account, close some open positions, or disregard the call.
If you ignore the margin call, you risk reaching your broker’s stop-out level. Triggering a stop-out will force your broker to close your positions until your balance exceeds the stop-out level.
With Great Profits Come Great Responsibilities
Trading on margin can let you gain substantially larger returns with only a small amount of your capital.
However, margin trading is as dangerous as it is rewarding. While it magnifies your potential gains, it also amplifies the risks you are taking. Always ensure you completely understand your broker’s margin policies before trading.
The last thing you want to experience is liquidating your trades because you haven’t read that your broker treats the margin call level and stop-out level as the same.
Many traders have lost their capital and more by trading on margin without proper understanding and adequate risk management measures.
In the next lesson, you’ll learn some of the best practices when using leverage.
