The margin level is a percentage based on the size of the available margin (usable margin) concerning the used margin. In other words, it is the ratio of equity to used margin . Margin is one of the most important concepts in Forex trading. In short, a margin on the Forex market is the amount needed to maintain open positions. It is not a fee or transaction cost, but the part of the capital on the account that is reserved and assigned as a margin. Trading based on margin can have different consequences - both positive and negative - as both gains and losses can be significantly increased. The broker collects the margin from the client and then combines it in the pot with other clients' margins. Brokers do this to enable you to trade across the entire interbank network. Forex margin is often expressed as a percentage of the full value of a selected position. For example, most of the required Forex margin is: 1%, 2%, 4%, 10%. Based on the margin required by an FX broker you can calculate the maximum leverage that can be applied to your trading account.
Types of margin level
Margin deposits are divided into two types of deposit:
- Initial deposit is a deposit that an investor makes immediately before placing an order for futures contracts. Such a deposit is made by blocking an amount equal to the value of the accrued deposit on the account of the money invested. When making a deposit, we do not make any money transfers and we do not entrust any other people with any money. Regulations held by brokerage houses may allow for placing securities on the account of the depository, e.g. bonds or shares.
- A relevant margin is a margin that determines the minimum value of funds that must be held in the account by an investor. As you know, as a result of the market equation procedure, different types of funds held in the margin can both decrease and grow. However, it is not possible to fall below the proper margin. If such a situation were to occur, the investor would be called upon to supplement the funds by a brokerage house. The investor replenishes the deposit up to the amount of the initial deposit designated for a given day. If the funds are not supplemented, the brokerage house may close the position.
The functioning of derivatives in the financial market is inextricably linked to the concept of leverage, which can be achieved by margin deposits .
Advantages of relevant margin level
A great advantage of derivatives is the fact that the investor does not need to have a full amount of money equal to the value of the instrument he buys (or the base on which it is built), but only a fraction of it called a margin. In contrast to cash instruments, the settlement of forward transactions is deferred. This feature is associated with another advantage and at the same time the need to introduce a margin to protect the parties against failure to perform the contract. Therefore, the purpose of making a deposit is to minimize the risk .
Calculation of margin level
The margin level is calculated as follows: Margin level = (Equity / Used Margin) x 100. Brokers use margin to detect whether or not foreign currency investors can take new positions .
Margin call limit
Different brokers set different limits for the margin level, but most of them choose 100%. This limit is called a margin call limit. From a technical point of view, this limit means that once the margin call limit reaches 100%, you can still close your positions, but you cannot take new ones. If you have a 100% limit, a margin call occurs when your account equity is equal to your deposit. This is usually the case when an investor has a loss-making position and the market moves quickly in an unfavourable direction. When the equity is equal to the deposit, no new positions can be taken .
Application of margin level
Margin level, in other words, is a margin. In Forex trading, CFDs (Contracts for Difference; CFDs) mean the level of collateralization of a position in a financial instrument (e.g. a long or short position in a German stock index DAX) that uses leverage. The level of required margin is determined, among other things, by the leverage, which is individual for a given instrument, e.g. a CFD contract. Margin level plays a very important role in trading. Before you open a position, you need to be aware of what the margin level is. The main factors affecting the margin level are the volume of the trade, the type of instrument and the leverage. We should not forget about the individual rules of individual brokers .
Consequences of margin level
The consequence of margin level and not contributing the full amount of the derivative is that the underlying characteristic of the market is leverage. It allows the investor to achieve a much higher rate of return than if he had invested the same amount on the spot market. The leverage mechanism multiplies the potential return that can be achieved . The leverage effect is used in the derivatives market, where it allows to increase potential profits due to the leverage effect. For example, to conclude a transaction and buy a futures contract, it is not necessary to have all the money to cover it - in practice, it is required to have only a deposit of 5-15% of the contract value . This makes it possible for an investor with a higher risk inclination to invest only a fraction of the contract value to be able to make profits and losses at the level that would be achieved if he invested the full amount in the underlying instruments .
Examples of Margin level
- The margin level is calculated by dividing the equity in an account by the used margin. For example, if a trader has an equity of $10,000 and a used margin of $2,000, the margin level would be 500%.
- Another example of a margin level calculation is when a trader has an equity of $5,000 and a used margin of $1,000. In this case, the margin level would be 500%.
- A third example of a margin level calculation is when a trader has an equity of $7,500 and a used margin of $3,000. In this case, the margin level would be 250%.
Limitations of Margin level
The margin level has several limitations, including:
- Margin level does not consider the current market price of the asset, which could change rapidly and cause losses on the position.
- Margin level does not take into account the cost of borrowing the money to fund the margin account. This cost is usually a factor when trading on margin.
- Margin level does not account for the potential for slippage or the size of the spreads, which can also cause losses on a position.
- Margin level does not consider the effect of leverage, which can amplify both profits and losses.
- Margin level also does not consider the time it will take to execute a position, which can have an effect on the overall risk of the trade.
The margin level is an important tool in forex trading to monitor the risk level of a trading account. Besides the margin level, there are other approaches that traders can use to monitor and manage their risk exposure, such as:
- Setting a leverage limit: Leverage limits provide traders with a way to limit the amount of money they can risk on a single trade. This can help manage risk by limiting the amount of funds exposed to the market.
- Using stop-loss orders: Stop-loss orders enable traders to automatically close a position when it reaches a predetermined level at which time money is no longer at risk.
- Risk/reward ratio: This approach involves setting a goal for the amount of profit you hope to make and the amount of risk you are willing to take.
- Position Sizing: This approach involves setting a maximum size for each trade. This can help manage risk by limiting the amount of funds exposed to the market.
Overall, the margin level is an important tool to monitor the risk level of a trading account and there are other approaches traders can use to manage their risk exposure.
- ↑ M. Wu, S. Pang 2010, pp. 1
- ↑ S. Figlewski 2006, pp. 385 – 416
- ↑ M. Wu, S. Pang 2010, pp. 1 - 3
- ↑ I. Shayea, et al. 2019, pp. 242 - 245
- ↑ S. Figlewski 2006, pp. 385 – 416
- ↑ N. Wei-Wei, et al. 2013, pp. 4 - 8
- ↑ T. Kao, C. Lin 2009, pp. 1704 - 1713
- ↑ I. Shayea, et al. 2019, pp. 245
- ↑ T. Kao, C. Lin 2009, pp. 1712
- ↑ T. Kao, C. Lin 2009, pp. 1713
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Author: Aleksandra Morzywołek