Margin trading: what it is and how it works in Forex

The need for more funds is a common problem among traders. However, any trade should bring profit. In this article, we will review margin trading as a potentially lucrative way of increasing potential returns and consider the risks associated with it.

Traders are looking for various options to increase their potential returns. But what can traders do if they have little money in their accounts? Trading on margin can be one of the ways to add capital to your account. But is it a safe strategy to follow? Let's figure it out.

What is margin trading?

Another term for margin trading is leverage trading. In the financial market, opening a position, whether long or short, using a deposit is margin. Put differently, when a trader takes trades on margin, it simply implies that the broker is loaning the money to the trader.

There are two types of accounts that you can open with a Forex broker: a cash account and a margin account.

When you open a cash account, the amount of money you put into the account equals the amount you can leverage to buy stocks. For example, if you deposit $1000 into your cash account, you can use this amount in total to buy stocks or securities.

It's worth noting that not all brokers separate accounts and differentiate them as cash or margin. With brokers such as Octa, you can use margin trading as a strategy within your usual account, whether a real cash account or a demo one. In that case, the loan will be called leverage, a virtual credit the broker provides to a client.

Different rules apply to a margin account.

A margin account allows you to ask your broker for a loan to increase the amount you can use to buy stocks and securities.

For example, suppose a trader wants to buy ten shares of a stock, each valued at $100. If the trader decides to buy these stocks via a traditional broker, the trade would require (10 shares x $100= $1000). If a trader is given a margin rate of 20%, he needs only $200 while at the same time getting exposure to the full value.

In other words, the trader is only required to contribute $200, and the broker provides the remaining $800 as a loan.

In the most basic definition, margin trading occurs when a trader borrows money from a broker to place an order.

While this strategy may seem appealing at first glance, it can be tricky, especially for newbies in the trading market.

Let's see why.

If your broker provides you with an additional loan and you make a good investment, you will have a double profit compared to using only your money. However, the dark side of margin trading is that you will experience a double loss if you make a terrible investment. This underscores the importance of understanding the risks involved in margin trading.

Forex trading on margin allows traders to increase their position. Margin enables traders to open trading positions with borrowed funds, giving them greater market access with less initial capital costs.

However, margin trading covers considerably more risks than standard stock trading on a cash account. So, such a 'game plan' should be considered by experienced traders with a high tolerance for risk.

How does margin trading work?

Margin trading gives a trader full exposure to a market using a fraction of the capital needed for an outlay. The margin deposit is simply a percentage of the whole position size. Therefore, the broker determines the margin rate, and thus, markets with higher volatility require a more considerable margin to maintain in case the trades are against the trader.

Margin trading is like getting a 10-to-1 advantage: for every dollar you put in, you can control ten dollars' worth of investments. But this is a double-edged sword. If your investments go up, you make substantial profits. But if they go down, you lose much more quickly, too. It's a high-risk and high-reward approach.

If the value of your investments declines, your broker may require additional funds, which may result in the automatic liquidation of your assets to satisfy the outstanding margin loan. In this type of trading, you owe the broker the money you borrowed, regardless of your investment's performance. This highlights the need for careful risk management in margin trading.

Difference between margin and leverage

There is a close relationship between margin and leverage. When a trader opens a leveraged trade, whether long or short, he does so by using the margin deposit. The margin deposit gives the trader the opportunity to take a larger position by using just a fraction of the initial deposited capital. In simpler terms, leverage is like a financial 'boost' that allows you to control a larger investment with a smaller amount of your own money.

Components of margin trading

For those interested in profoundly understanding margin trading, it is essential to break this process down into constituents and examine each in detail.

Minimum margin

This term refers to the smallest amount of funds you need to have in your trading account before you can start using the margin to trade. This amount varies between brokers, but some rules set a minimum that all brokers must adhere to.

Initial margin

Initial Margin is the money you need to open a new trade in your trading account, calculated as a percentage of the total trade value. You might also hear it called the deposit margin.

Maintenance margin and margin call

The maintenance margin is the minimum amount of funds you need in your trading account to keep your open trades from being automatically closed by your broker. It's like a safety net to ensure you have enough funds to cover potential losses. If your trades lead to financial losses and your account balance drops below the maintenance margin level, you'll get a margin call—a warning to deposit more money or close some positions to avoid your trades being closed. In this case, you need to deposit more funds immediately, or the broker will close some of your trades—even profitable ones—to cover potential losses and prevent your account from breaking completely.

Advantages and disadvantages

Margin trading opens inaccessible doors with deposits alone, particularly for high-volatile assets. It also allows for significantly broader diversification, enabling you to spread your investment across more assets to mitigate risk. This leveraging is a key strategy for professionals who aim to maximise their chances of success across various market positions.

On the other hand, using borrowed funds drastically increases your risk. A 50% drop in the value of your investments could completely wipe out your initial deposit because you still owe the broker the money you borrowed. Even worse, if your account value falls too low—below the maintenance margin—your broker will require you to deposit more funds instantly—and a margin call will occur. If you can't, they'll sell off your investments to cover the loan, possibly leading to substantial losses.

Example

Let's say you want to trade €20,000 in the Forex market. You don't need the full amount upfront. Your broker might require a 2% margin, meaning you deposit only €400. The broker essentially lends you the remaining €19,600 to make the trade. This €400 acts as collateral.

This collateral is your 'margin'. If the exchange rate moves against you and your losses approach €400, your broker will issue a 'margin call'. You need to deposit more money or close your trade to cover potential further losses and protect the broker. It's like a warning that your losses are nearing your collateral. In volatile times, the broker might close your position automatically to prevent significant losses for both of you, notifying you afterward.

Is margin trading right for you?

When deciding whether this one is right for you, remember a few essential aspects. Margin trading is far riskier than using only your finances. If the trade goes south, you could lose more than you initially invested, and interest charges will reduce your profits even if you win.

However, if you understand the risks, margin trading can amplify your returns and let you invest in more securities and currencies. To minimise risk, start with small-margin loans, keep your trades short-term to avoid high interest and market volatility, and actively monitor your investments. It's proactive, as margin trading demands particular attention and quick decision-making.

Summary

• Margin trading lets you borrow funds from your broker to buy assets, enabling you to invest more than you have and diversify your holdings.
• However, it magnifies profits and losses, making it riskier and more volatile than investing only your funds.
• The minimum margin is the smallest amount of money you must have in your trading account to start using margin to trade. The initial margin is the sum you need to open a new trade.
• A margin call is a warning to deposit more money or close some positions to avoid your trades being closed.
• Margin trading requires intense focus, stress tolerance, and quick decision-making.