The exchange rates used in this article are for illustrative purposes, so the exchange rates themselves are not updated, since it serves no pedagogical purpose. Foreign exchange rates vary continuously, so current exchange rates may deviate largely from what is presented here. Nonetheless, the exchange rates were accurate when the article was written, and regardless of the current rates, the exchange rates used here still illustrate the principles presented in this article, which do not change.
Most forex brokers allow a very high leverage ratio, or, to put it differently, have very low margin requirements. This is why profits and losses vary greatly in forex trading even though currency prices do not change all that much — certainly not like stocks. Stocks can double or triple in price, or fall to zero; currency never does.
Because currency prices do not vary substantially, much lower margin requirements are less risky than it would be for stocks. Note, however, that there is considerable risk in forex trading, so you may be subject to margin calls when currency exchange rates change rapidly.
What is Free Margin?
Such leverage ratios are still sometimes advertised by offshore brokers. However, in , US regulations limited the ratio to The purpose of restricting the leverage ratio is to limit the risk. The margin in a forex account is often called a performance bond , because it is not borrowed money but only the equity needed to ensure that you can cover your losses. In most forex transactions, nothing is bought or sold, only the agreements to buy or sell are exchanged, so borrowing is unnecessary.
Thus, no interest is charged for using leverage. Thus, buying or selling currency is like buying or selling futures rather than stocks.
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The margin requirement can be met not only with money, but also with profitable open positions. The equity in your account is the total amount of cash and the amount of unrealized profits in your open positions minus the losses in your open positions. Your total equity determines how much margin you have left, and if you have open positions, total equity will vary continuously as market prices change.
Chapter 8. How Margin Trading Works
Instead of a margin call, the broker may simply close out your largest money-losing positions until the required margin has been restored. The leverage ratio is based on the notional value of the contract, using the value of the base currency, which is usually the domestic currency.
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Often, only the leverage is quoted, since the denominator of the leverage ratio is always 1. The amount of leverage the broker allows determines the amount of margin that you must maintain.
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Leverage is inversely proportional to margin, summarized by the following 2 formulas:. To calculate the amount of margin used, multiply the size of the trade by the margin percentage. Subtracting the margin used for all trades from the remaining equity in your account yields the amount of margin that you have left.
If you do these things and all is well, you are safe for now but really should close out your trades as soon as possible and return to a demo account. At this point, your trades will be closed automatically by your broker starting at the ones that are failing most badly. If necessary, all of your trades will be shut down in order to meet the minimum margin requirement.
Margin Call: What Is It?
This combined system contains no warning — it simply closes your trades. How do you avoid this horrible thing happening to you? Manage your money in a rational manner; only use leverage if it makes sense for you to do so. Just because it is there does not mean you have to use it! A lot of profitable traders — most actually — only trade about 2.
There is nothing wrong with doing it this way — you are more likely to make it in the long run.
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And if you do hit a stop-out level or get a margin call? Go back to demo testing until you can trade profitably again, and then get back to live trading when you are truly ready. Example 1. Example 2. Example 3. If you want to get news of the most recent updates to our guides or anything else related to Forex trading, you can subscribe to our monthly newsletter.
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