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What is margin trading? It is essence and principles on the Forex exchange

 

 

Most of you are probably already aware that all work on the forex financial exchange is built on the principle of margin trading. For the first time, margin trading was applied in practice in 1986. In this article we will try to understand in detail what margin trading is, what elements interact with it, and what role it plays in a trader's work.

 

Margin trading is the implementation of operations for the purchase and sale of currency using credit funds that are provided to a trader, secured by a specific amount of money (margin). What is Forex margin is a collateral that makes it possible to get a loan (credit) to carry out transactions on the currency exchange.

The essence of margin trading is exchange operations with currency, without resorting to its real exchange. All trading on the currency exchange is carried out on a net basis, without the involvement of real funds. The operation of currency exchange, for profit, due to the difference in rates over a period of time, is called currency arbitrage. The essence of such a trade is that the trader will, without fail, carry out an exchange operation in the opposite direction and with the same volume. That is, if there was a purchase of currency, then after a while there should be a sale of the same volume of currency.

 

The use of the margin trading mechanism significantly increases the volume of transactions in the Forex market. The volume of a position that is traded on a currency exchange is called a lot on Forex, the size of a standard one lot is equal to 100,000 conventional units (dollars). There are also more simplified options, this is a mini lot, which is equal to 0.1 of a standard lot and a micro lot of 0.01 of a standard lot, and the typical transaction volume in the Forex market is several lots.

Such amounts are not available to small and medium investors, and the use of small amounts will not give a tangible effect, so in order to increase the volume of transactions, margin trading was introduced. This became possible thanks to the intermediary activity of brokerage companies, since then the number of participants in the Forex market began to grow significantly.

 

Leverage as the main element of margin trading

Margin trading is used in the foreign exchange market in the form of a credit, or also called, margin leverage. It differs from a regular loan, margin, in that the amount that is provided to the merchant is several times larger than the collateral or margin itself.

The formula for calculating the margin on Forex is as follows:

Margin = position volume / leverage

Forex free margin is the balance on a trader's account that is not used as collateral for open positions, in other words, free margin is the difference between the current size of the deposit and the margin that is used in an open position. This indicator is used to determine how many positions a trader can still open at the current time.

 

Leverage allows a trader to multiply his working capital from 10 to 1000 times, this makes it possible to make high profits with a small amount of his own funds.

In practice, it looks like this: to his account, which a trader opened with a brokerage company, he deposits an amount, for example $ 100, and independently chooses a leverage, say 1: 100. As a result, he will already have a sum equal to $ 10,000. But you cannot withdraw this money, it is provided to you only for making transactions for the purchase and sale of currencies, stocks, etc.

The choice of leverage is a very important point, it can both increase your income from the transaction, and completely drain your entire deposit. The leverage is chosen depending on the size of the deposit, if the deposit is not large, then to open a deal you need to increase it, but it is worth remembering that this increases the risk of losing the deposit, in order to limit possible losses, you always need to set a stop loss level for each open transactions, as it can protect your deposit from being completely drained.

 

Loss levels Margin Call and Stop Out - as regulators in margin trading

The loss or profit from the operation made by the trader, which is credited or debited from his account, is called the variation margin. If the level of variation margin, which is set by the brokerage company, is below the minimum, the trader will be considered bankrupt.

In order to avoid possible losses, brokerage companies set loss levels, upon reaching which, the broker can contact the trader with a proposal to increase the amount of the

collateral, this call is called the Margin Call, and the warning level is accordingly called the Margin Call Level. Usually this level is 25-30% of the amount of the collateral.

If funds to increase the collateral are not received, and the loss continues to grow, the broker can forcibly close the position (or positions), this is called Stop Out, the stop out level can vary from 10 to 20% of the collateral amount

 

In practice, it looks like this: a trader has a deposit of $ 5,000, he opened a transaction on the EUR / USD currency pair , with a lot size of $ 100,000 with a leverage of 1: 200, the margin in this transaction is $ 500, if there were no more positions open, the EUR / USD trade will be closed by Stop Out when a loss of $ 4900 is reached.

The Stop Out level in this case is 20% of $ 5000, that is, when the trader's deposit is $ 100, the position will be closed. Therefore, using a large leverage in trading, you need to be very careful and at the same time carefully monitor the size of the margin, and you should open positions in small lots.

You should always remember that the risk of trading will grow in direct proportion to the growth of margin funds.

 

On the Forex currency exchange, due to its speculative orientation, there are two stages of the transaction, opening and closing a position, this is called a full trade. If a buy position is not closed by a sell trade, the broker fixes the open position. Margin trading is carried out in two types of operations:

The choice of a currency pair for trading depends on various aspects and, which is very important, on your trading system. If you practice short-term trading, the main criterion is the liquidity of the currency pair, the higher it is, the more the currency pair is suitable for this style of trading.

 

Margin trading has gained such popularity due to its affordability. It provides access to speculative foreign exchange transactions, not only for large investors with large capital, but also for medium and small participants in the currency exchange.

Indeed, in order to carry out transactions, you need to have a sum, the size of which is only 1-3% of the transaction amount. A large number of participants in the Forex market leads to an increase in small transactions, which in turn increases the liquidity of the market and, as a consequence, its stabilization. On the other hand, if the majority of transactions are unilateral, this will lead to an increase in price fluctuations.

 

Using leverage for trading sharply increases the rate of profit if the price moves in the direction of an open position, but if the price moves in the opposite direction, this leads to an increase in losses to the same extent. All this leads either to an increase in capital or to a loss of invested funds.

Therefore, in order to prevent this, you need to choose the optimal value of the margin leverage, and also pay attention to the volatility of the quotes of the selected currency pair. Do not forget that with high volatility, using a large leverage can lead to significant losses.

Well, novice traders, I think this material on margin trading has shed some light on the general picture of trading in the Forex market, and now you know how these processes work.

 

 

 

 

Published on: 9/18/20, 5:31 AM