Understanding Margin

What is margin and how does it work?

Dealing with Risk

Any type of trading where you trade in a contract and have to settle the difference in price from between where you bought and sold involves a certain amount of risk. This is especially true if you are using leverage (which, as explained to you, gave you the ability to purchase a contract at a fraction of the actual value of the contract)

Let us take an example: Trader 1 has a $150,000 trading account, do not use leverage and purchases a FOREX currency pair. He purchases $100,000 of currency. Trader 2 has an account of only $1,500, but through his broker are able to invest in the same currency pair at a leverage of 100:1. He therefore only requires $1,000 to purchase the same $100,000 of currency. At close of business the currency pair is trading at 1.5400. Due to unforeseen circumstances (unforeseen for both traders), the currency pair opens the next morning at 1.5245 - that is a jump (loss) of (1.5245 - 1.5400) = -0.0155 points and with $100,000 worth of currency is equal to -0.0155 x 100,000 = -R1,550 loss.
For Trader 1 this is not a big deal, it is about 1% of his trading account, he easily absorbs the loss and make back his money on the next trade
For Trader 2 this is disastrous - a $1,550 loss on his $1,500 trading account wipes him out. Not only that, he also now owns the Exchange in the United States $50! (or worst, he ows someone somewhere in the world R600 - hopefully this someone does not come knocking with a couple of goons armed with baseball bats)

Yeah maybe, but this is a ridiculous example, such a move will never happen..?

The example above the GBP/USD currency pair, second week in May 2015, fourth bar from last, market close and next morning market open marked on the chart. These type of moves does happen and they wipe out small traders overnight.

Introducing Margin

Clearly the Exchange cannot allow the above to happen - how are they going to get the money from you? Margin (or a margin requirement) was introduced to safe-guard against this. The Exchange will determine the likely maximum size move that may happen in a specific market in a day and pose a restriction that any trader, wishing to trade in that specific market, should as a minimum have this amount of funds available in his/her trading account before he/she will be allowed to trade in that specific market. (Clearly the margin requirement will change over time as the market changes over time, it will also be different for every different market according to the characteristics of the market - a full discussion on how the Exchange determines the size of the margin requirement falls beyond the scope of this introduction). This minimum balance to be available in a trader's account before allowing the trader to trade a specific market is called the margin requirement for that market. It:

  • Protects the Exchange from a Trader taking on a position that is deemed too risky for the Trader to trade in
  • Protects the Trader (or the Trader's account) from unforseen movements in the market
  • Is a necessary safety measure to be put in place to allow Traders to trade on leverage
  • Will be imposed by your Broker on your trading account before you enter a transaction
  • Note that your Broker may add an additional margin requirement on top of the Exchange's margin should the Broker be of the opinion that the margin requirements are not protective enough to him as Broker

How does it work?

Your Broker will provide you with the margin requirements for every specific market that you wish to trade in. From the definition above, the margin requirement is the minimum sum of money that you need to have available in your trading account to allow you to open a position in a specific market. When you open the position, the margin amount will be taken out of your trading account and put aside - it is no longer available to you for trading, you no longer have access to it, you cannot withdraw it, it is taken out of your account - you will notice the trading balance in your account has dropped.

From now on the unrealized profit / loss of the position that you have entered will reflect on your available balance. Should your available balance at any point approach zero, your Broker will call you and request that you immediately deposit more funds (we call this a "margin call" - you will receive a margin call from your Broker). Should you fail to comply, the Broker will take action and close the position you have entered (if you bought something, he will sell you out, if you sold, he will buy you back). The moment the position is closed, the margin that was set aside is put back into your account and you may continue to trade like normal (of course your account balance will no longer be sufficient to open a position in the same market, but you may continue trading other lesser margin markets).
Again, let's take an example.

Account Balance Margin Unrlzd P/L Available Balance
$3000 $0 $0 $3000
We start with $3000 in our trading account
Next, we enter a transaction for which the margin requirement is $1000
$3000 $1000 $0 $2000
Market moves up, we make $120 profit then enter a second transaction with a margin requirment of $1500
$3120 $1000 $120 $2120
$3120 $2500 $120 $620
Large surprise movement of $580 against us, the broker calls and ask that we deposit more funds
$2540 $2500 -$460 $40
Before we can deposit funds, the market moves another $80 against us, the broker sells us out of both positions
$2460 $0 $0 $2460

What happened? The moment that the Broker closed the two positions we were in, (1) the margin got put back in our account and (2) we realized the, up to then unrealized, loss of $540.
Why did the Broker close us out? That last move of $80 againt us put out account balance at a negative balance, the risk was too high and we were closed out

What you see in action here is a risk management strategy, imposed by the Exchange and enforced via the Broker. It safegaurds

  • The Exchange in case you try to take on too much risk
  • The Broker against same
  • The Trader - maybe the trader is away from his home, maybe he is on leave, maybe he has lost Internet connection and is not aware of what the market is doing, whatever the reason, it is necessary to take precautionary measures

Margin is a safety measure, it is a good thing. Be happy for it!