Equity is one of the most important, yet least understood concepts in forex trading. As you already know, in order to start trading you need to make an initial deposit with a broker. However, only a small percentage of traders actually understand all the terminology that is connected to equity in forex, such as the balance, margin, unrealized profit or loss, equity and account size.
All these concepts are intertwined, and each one has a direct impact on the other ones. In this article, we’ll cover what all those concepts stand for, and how they impact your equity in forex trading. In addition, we’ll show you an easy way to prevent margin calls in trading. So, let’s start.
What is Equity in Forex Trading?
Equity is simply the total amount of money you have in your trading account. However, if you have open positions in the market, your current equity will change according to the unrealized profit or loss that your open positions have accrued. Once you close all your positions, all unrealized profit or losses will be added to your equity, and your equity will be equal to your new account balance.
Many factors affect the value of your equity, so let’s take a look at a typical trading platform’s overview of them. This list is composed based on the MetaTrader 4 platform, but the concepts are the same on different trading platforms as well.
Video: Equity Management and Forex Trading
Your account balance is equal to your total equity if you have no open positions in the market. The difference between these two concepts arises when you open and hold a new trade. In this case, your account balance will still be the same as prior to opening the trade, but your equity will be affected by the unrealized profit or loss of the trade.
If the position incurs an unrealized loss, your equity will be deduced by the amount of the unrealized loss. If your position is in the positive territory, i.e. you have an unrealized profit, the amount of the unrealized profit will be added to your equity. Your account balance will only change once you close all open positions, and will be equal again to your equity. That is, all unrealized profits and losses will become realized and added to both your equity and account balance.
By now, you know that your open positions affect the value of your equity through their unrealized profits or losses. Unrealized profits and losses become realized once your open positions are closed, and your balance will change accordingly. Many trades will occasionally see losses before they turn around and end up with a profit.
While you need to have confidence in your analysis and trading strategy, most profitable traders are extremely impatient with their losing positions. They cut their losses, but let their profits run. This is a completely opposite approach to losing traders or beginners, who hope and wait for their losing trades to become profitable but close their profitable positions too early. Take care of this side note if you want to grow your equity.
Margin and Leverage
The next concepts that affect your equity are margin and leverage. The forex market is a highly-leveraged market. This means, you can control a much larger position size with a very small sum of money. When you open a leveraged position, a part of your account size will be put aside as a collateral for the position, called the margin. If you want to learn more about margin and leverage check out this guide.
For example, if you use a 100:1 leverage on your account, you only need $1,000 as the margin to open a position worth $100,000. Now, let’s say your balance is $10,000. If you open that position, your balance will still stay the same ($10,000), your margin for the trade will be $1,000, and your free margin will equal to $9,000.
The unrealized profit or loss of the position will affect your equity – in other words your equity will constantly change with the change in the pair’s exchange rate, as will your free margin. While your margin will stay constant (being just the collateral for the trade), your free margin will rise with unrealized profits, and fall with unrealized losses. Taking this all together, your equity will be equal to:
Equity = Margin + Free Margin OR Equity = Balance + Unrealized Profits/Losses
Many trading platforms also display your margin level, which is simply your equity divided by your margin, displayed in percentage terms. In our example below, in case our position is on breakeven (no unrealized profits or losses), our margin level would be $10,000 / $1,000 x 100 = 1,000 %.
A margin call happens when your leveraged position goes against you and your free margin falls to zero. This means that you have no capital left to withstand negative price fluctuations, and your broker will automatically close your positions to protect his (and your) capital. After you receive a margin call, all that is left in your trading account is the initial margin used for the open positions.
How to Prevent a Margin Call
Margin calls are a nightmare for traders. Fortunately, there are ways to effectively prevent them from happening. First, you need to clearly understand all the concepts covered in this article, and how they’re connected. And second, always know the risk of trading on leverage. If you open so many leveraged positions that your free margin is not enough to withstand even a small amount of losses, you’ll probably receive a margin call.
Don’t let the numbers get out of control – always place stop-losses and make sure that the sum of all unrealized losses (i.e., a scenario where all your stop-losses are hit) never exceed your free margin. This way, you’ll rest assured that you’ve enough capital to withstand all losses on your open positions.
Before You Trade
Understanding how equity, balance, unrealized profits and losses, margin and leverage are intertwined is very important for all forex traders. This way, you’ll be able to take calculated risks and prevent the notorious margin call from happening. Take care when opening leveraged positions and control your free margin, don’t risk too much of your account balance and – with a sound trading strategy – watch your trading equity grow.