What is Free Margin?

What is Free Margin? Lesson No 34

In the world of forex trading, understanding the idea of “free margin” is essential for efficiently managing positions.

First, let us differentiate between two types of margins: “used” and “free.”

Used Margin is the entire amount of margin necessary for all of your current open positions, as discussed in the previous course.

Now let’s look at Free Margin. The free margin is the difference between your equity (the overall worth of your account, including profits and losses) and the used margin. Simply put, it is the part of your account balance that is not used as margin for your current trading.

Consider free margin to be a form of affordability within your trading account. It is the amount of money you have available for opening new positions or maintaining potential losses in existing transactions without activating a Margin Call or Stop Out.

In other terms, free margin serves two main purposes:

It is the funds that you can use to start fresh trades.

It serves as a cushion against bad price changes in your current trades before your broker steps in with a Margin Call or Stop Out.

Don’t worry about the details of Margin Calls and Stop Outs just yet. We’ll go over those in depth later. For the time being, only remember that these are undesirable effects, similar to unpleasant surprises such as unexpected acne breakouts.

How to Calculate Free Margin?

Understanding “Free Margin” is essential in forex trading since it represents the amount of available cash in your trading account after deducting the margin required for open positions.

To calculate the Free Margin, subtract the entire Used Margin from the Equity. Your Equity is the whole value of your trading account, including gains and losses, whereas Used Margin is the portion of your account balance that is now locked up in open trades.

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When your open trades generate profits, your equity improves. As a result, your Free Margin increases as your Equity increases. It’s worth noting that these profits are referred to as “floating profits” until the positions close.

On the other hand, if your open positions begin to lose money, your equity will drop. As a result, your Free Margin decreases. These losses, known as “floating losses,” drain your equity, destroying your Free Margin until the positions are terminated or the losses are compensated by future market moves.

In basic terms, Free Margin informs traders of their available cash to establish new positions or withstand unfavourable market swings without suffering margin calls or stop-outs. Monitoring Free Margin is essential for risk management and making sound trading decisions in today’s unpredictable forex market.

Example: No Open Positions

In this case, if you’ve deposited $1,000 into your trading account and have no active positions, your Free Margin equals your Equity because there are no used margins to consider. Therefore, your Free Margin is also $1,000. This is because your Equity and Free Margin are calculated using the entire amount you’ve put into your account, and no trades have yet used any of that deposit.

Step 1: Calculate Equity

If you don’t have any open positions, calculating the equity is simple.

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In the context where there are no open positions, Equity indeed equals the Balance. Since there are no trades underway, there are no floating profits or losses to affect the Equity. Therefore, in this scenario, the Equity is equivalent to the Balance, which is $1,000.

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Step 2: Calculate Free Margin

If you have no open positions, the Free Margin is the same as the Equity.

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In the absence of any open positions, no margin is used, indicating that the Free Margin, Balance, and Equity are all equal. Each of these numbers represents the total amount of funds available in the trading account, which in this example is $1,000. 

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Example: Open a Long USD/JPY Position

Now let’s make things a little more complicated by making a trade!

Let’s say you have a $1,000 account balance.

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Step 1: Calculate Required Margin

To calculate the Required Margin for opening the position, utilise the Margin Requirement stated as 4%.

Given that the position’s Notional Value is $10,000 because USD is the base currency, multiply it by the Margin Requirement.

Required Margin = Notional Value x Margin Requirement

Required Margin = $10,000 * 4%.

Required Margin = $10,000 multiplied by 0.04

Required Margin: $400

As a result, to establish a long position on USD/JPY with one mini lot (10,000 units), you’ll need $400 as the required margin.

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If your trading account has a value in USD and the Margin Requirement for the trade is 4%, the required margin to open the position will be $400, based on the trade’s Notional Value of $10,000 (1 mini lot).

Step 2: Calculate Used Margin

When just one position is open, the Used Margin will be equal to the Required Margin for that position. In this situation, because you entered a single trade with a required margin of $400, the used margin will also be $400. This is the amount of margin that is currently locked up or used for your open position.

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Step 3: Calculate Equity

Your equity is calculated as the sum of your balance and your floating profit/loss (P/L). Because the position is currently at break even point, your floating P/L is $0; therefore, your equity is equal to your balance.

As a result, if your original balance was $1,000 and your floating profit/loss is zero, your equity stays $1,000.

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The Equity in your account is now $1,000.

Step 4: Calculate Free Margin

For calculating the free margin, we use the formula:

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The Free Margin is $600.

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As you can see, equity may also be understood as the total of your used and free margin.

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Recap

During this lesson, we learned some essential terms:

Free Margin: This is money that is not locked into open positions and can be utilised to open new ones.

When the Free Margin reaches 0 or smaller, you are unable to initiate more trades.

In earlier lessons, we discussed:

Margin Trading: Learn how your margin account works.

Balance: The amount of funds in your trading account.

Unrealized and realised P/L: How gains and losses affect your account balance.

Margin: The amount placed aside when you open a position.

Used Margin: The total margin required to keep all open positions.

Equity is your balance including the floating profit or loss on all active positions.

Now we’ll look at Margin Level.