In forex trading the concept of equity refers to the total value of a trader’s account when any open positions have been factored into the equation. When the trader has active positions in the market (i.e. when the trader has open trades), the equity on the forex account is simply the sum of the margin put up for the trade from the forex account plus the free or usable margin , which is called equity. When there are no active trade positions, the equity is the same as the free margin, and is also the same as the balance on the account.
Computing how much money you have at your disposal when trading forex is a complex procedure. One must take into account one’s opening balance, one’s open positions and their profit/loss status at any given moment. Considering that these positions are usually leveraged, profit and loss must take the level of leverage into account. Loss should also take into account swaps and rollover fees. Put more simply, balance is the amount of money one has in one’s account when there are no open positions. Equity is one’s balance plus/minus leveraged profits/losses.
Trading in foreign currencies market poses a fast-paced challenge to speculators. The market stays open around the clock, five days a week and allows you to build several large positions with the use of margin. A little cash can open a big contract in the forex market, meaning high risks as well as potentially high rewards. Before dipping into currencies make sure you clearly understand the difference between account balance and account equity.
The account equity consists of the cash balance plus the value (positive or negative) of open positions. As the contracts rise or fall in value, so does the account's total equity. If a trader's open positions lose serious value, his equity may fall below a "margin maintenance level." This means the broker will either require more cash or automatically close out the losing position to prevent any further loss. A typical margin level may be 10 percent of the opening balance. A contract or combination of contracts losing 91 percent of the balance, for example, will trigger a margin call or position closing by the broker.
Uses of Equity
For example: Equity is your account balance and the floating profit/loss of your open positions:
Equity = Balance + Floating Profit/Loss
When you don’t have any open position then there are no floating profit/loss which means your account equity and balance are the same. If for example, your starting account balance is $5000, when you have some open positions and that they are $1,500 in profits in total, then your account equity is your account balance of $5000 plus $1,500. If your positions were $1,500 in losses, then your account equity would be your account balance of $5000minus $1,500.
When you have no position, no money from your account is used as the margin. Therefore, all the money you have in your account is free. As long as you have no position, your account equity and free margin are the same as your account balance.
Let’s say you have a $5,000 account and you have some open positions with the total margin of $500 and your positions are $200 in profit.
Equity = $5,000 + $200 = $5,200
Free Margin = $5,200 – $500 = $4,700
Equity and free Margin
Next very important fact to consider is the margin level. Brokers use it to determine whether the traders can take any new positions or not. Different brokers have different limits for the margin level, but this limit is usually 100% with most of the brokers. This limit is called Margin Call Level. 100% margin call level means if your account margin level reaches 100%, you can still close your open positions, but you cannot take any new positions.
Let’s say you have a $10,000 account and you have a losing position with $1000 margin. If your position goes against you and it goes to a -$9000 loss, then the equity will be $1000 ($10,000 – $9,000), which equals the margin. Therefore, the margin level will be 100%. If the margin level reaches 100%, you will not be able to take any new positions, unless the market turns around and your equity becomes greater than the margin.
If the market keeps on going against you, the broker will have to close your losing positions. Different brokers have different limits for this too. This limit is called Stop Out Level. For example, when the stop out level is set to 5% by a broker, the platform starts closing your losing positions automatically if your margin level reaches 5%. It starts closing from the biggest losing position.
Margin to Equity Ratio
A margin trade requires borrowing money from your broker. Borrowing money to trade stocks or other securities has a lot of appeal for investors because of leverage, which simply means you put up less money to make a trade than a cash purchase requires. Your broker wants assurance that the money you borrow will be returned. That’s when your margin equity becomes important.
The margin to equity ratio is a term used by speculators, representing the amount of their trading capital that is being held as margin at any particular time. Traders would rarely (and unadvisedly) hold 100% of their capital as margin. The probability of losing their entire capital at some point would be high. By contrast, if the margin to equity ratio is so low as to make the trader's capital equal to the value of the futures contract itself, then they would not profit from the inherent leverage implicit in futures trading. A conservative trader might hold a margin-equity ratio of 15%, while a more aggressive trader might hold 5%.
The obvious question is "what is the right margin-to-equity ratio to maintain?" If your only goal is to maximize your profitability there seemingly is no reason to limit your margin-to-equity ratio. However, on the other side is the risk exposure. While the margin-to-equity ratio does not measure your actual risk, it does give you a quick and easy way to get a handle on the relative level of exposure you have in the market place at any given point in time. The ultimate goal is to maximize your profitability while minimizing your exposure to risk.