Forex and the forex market
Forex, or FX, stands for foreign exchange, the exchange of the currency of one country for another country’s currency.
The foreign exchange market (forex market) is where currencies are traded and is by far the largest and most liquid market in the world. It is also known as the currency market.
The forex market is unique in the sense that it is not a central marketplace. Currency trading is conducted electronically. Put another way, all foreign exchange transactions take place via computer networks between all those involved in forex trading.
Equity in the accounting world
In the accounting world, equity refers to the value of a company’s shares. More commonly known as shareholders’ equity, it refers to the amount of capital contributed by the owners (shareholders) of the company. Put differently, equity is the difference between a company’s total assets and its total liabilities.
Equity in forex
Equity is one of the most important aspects of forex trading. However, it can not be explained separately from other important concepts which are interwoven with equity.
Forex equity is intertwined with other essential factors like leverage, margin and balance and each one has a direct impact on the others.
Therefore, it is especially important for forex traders to understand the interrelation between these concepts in order to retain capital while trading and to avoid encountering a margin call.
Equity and balance
Equity, also called account equity, represents the current value of a trader’s trading account. If the trader does not have any open positions, then the equity is the same as the account balance.
An open position is when a trader established or entered a transaction that has yet to close with an opposing transaction. An open position is the result of a buy, a long position, a sell, or a short position.
A long position is when a trader expects the value of a currency to increase and buys first to sell it later at a higher price. A short position is when a trader anticipates the price of a currency to decrease, and hence, sells the currency first to buy it later at a cheaper price.
However, the situation changes when the trader has open positions in the forex market since the trader’s current equity will change according to the unrealized profits or losses that the open positions have accrued.
For example, a trader starts trading with $500 and realizes a profit of $100 from a transaction. The account balance will still be $500, but the forex equity will be showing an adjusted amount of $600. Alternatively, if a loss of $100 of was incurred, the account balance would still be $500, but the equity would be $400.
Once the trader closes all positions, all unrealized profits or losses will be added to his/her equity, and the equity will be equal to the new account balance.
To summarise:
- Equity shows the real-time calculations of your profits and losses and takes into account both open and closed positions. It shows the real-time amount of your funds.
- Balance is the total amount of the money you have in your trading account before taking any position. It reflects your profits and losses from closed positions and is not the real-time amount of your forex account.
Therefore, if there are no open positions, then your equity and balance are the same. However, if you have open positions, the balance and equity differ.
What is leverage?
Leverage is a feature offered by forex brokers to forex traders. With this facility, traders are enabled to trade large amounts of forex with having smaller amounts of money in their trading accounts.
A leverage of 200:1 indicates you can trade 200 times more than the money available in your trading account.
For instance, with a leverage of 200:1, you can buy $200 by paying only $1.
Therefore, to buy $200,000 (one lot), you should pay only $1 000.
A lot is a specific amount in which forex is traded. A standard lot is 100,000 units of the base currency, the first currency appearing in a currency pair quotation. There are also mini, micro, and nano lot sizes that are 10,000, 1,000, and 100 units.
Explaining margin in forex trading
In the forex market leverage plays a major role, and the concepts of leverage and margin are interrelated.
Margin is the part of your trading account put aside as a collateral to utilise your leveraged position.
There are different types of margin in forex trading:
Free margin
The difference between your account equity and the required margin to open positions is called free margin. When you have no positions, all the money in your account is free to trade with.
It is also known as usable of available margin.
Example: When you have a trading account of $5 000 with no open positions, your free margin will be $5 000. However, if you are in a position with a required margin of $500 and your positions in profit are $250, then it will look like this:
Equity = $5 000 + $250 = $5 250
Free Margin = $5 250 – $500 = $4 750
Required margin
Required margin is the amount of your trading account that will be placed and locked in the positions that you take. Each position you open will have its own required margin amount.
Required margin is also referred to as deposit margin, entry margin, initial margin, floating margin, and margin held.
Required margin is calculated based on the leverage.
Examples:
Without leverage: You have a trading account of $5 000 and want to buy 1 500 EUR against the USD, with the exchange rate of EUR/USD 1.5. You will be required to put up $2 250 in account funds to be locked in this position as collateral. The $2 250 is called required margin.
With leverage: The same scenario as above, but you have a leverage of 100:1. Only $22.50 ($2 250 / 100 = $22.50) of your account will be locked as required margin.
If you close your EUR/USD position, the $22.50 required margin will be released, and the amount will be available in your trading account.
Used margin
Used margin is the total of all the required margin of all the open positions. Put differently, it is all the margin that is locked up that can not be used to open new positions.
What is the margin level?
Margin level is the ratio of equity to the used margin: (Equity/used margin) x 100%. The trading platform used by the forex trader will automatically calculate and display the margin level.
Margin level is important, because:
- It enables you to know how much of your funds are available for new transactions.
- Forex brokers use margin levels to calculate whether traders can open additional positions. Usually, brokers have a 100% margin call level. The implication is that you will not be able to open new positions if your equity equals or is less than your used margin. To open new positions, existing positions will have to be closed first.
What is a margin call?
A margin call occurs when your free margin falls to zero. The implication is that you have no capital left to hold out against negative price fluctuations, and your broker will automatically close your positions to protect both his/her and your capital. The effect of a margin call is that all that is left in your trading account is the initial margin used for the open positions.
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