Introduction
In the forex market, the exchange rates of currency pairs are always fluctuating. This is why a winning trade can suddenly reverse its direction and may result in a loss. To limit losses and protect their capital, forex traders monitor their equity and deploy various risk management tools and strategies. In this article, we will explain equity in forex trading and its importance to traders.
Highlights and Key Takeaways
- Equity is the real-time value of your account, especially when you have open positions. It is the sum of your account deposit and the floating profits or losses from open positions.
- Balance is the total realized funds available in your account. When there are no open positions, balance is equal to equity.
- Equity helps traders to evaluate open trades and intervene if necessary. Brokers also use it to calculate margin levels; which determine ‘margin calls’ and ‘stop out’ levels.
- Forex traders protect their equity by using stop-loss orders when trading and also by diversifying their assets portfolio.
What Is Equity in Forex Trading?
Understanding Equity in Forex Trading
Equity is the value of a forex trading account. It is calculated as the aggregate of the account balance and unrealized profits or losses from open trades.
Equity = Account balance + floating profits/losses from open positions.
The equity of a forex account represents the true value or state of the account with respect to open positions. Its value keeps changing to reflect potential profits or losses aggregated from all open positions.
A glance at the equity of an account tells a forex trader how his trades are doing. Assuming multiple positions were opened, the equity may signify that it is time to cash out your profits or exit some positions to mitigate losses.
Equity Vs. Balance in Forex Trading
When you open a forex trading account, the next step is to deposit funds into it as your trading capital. The amount of money in your trading account is referred to as ‘account balance’ or simply ‘balance’. It is the amount of money available for opening positions.
Balance is affected when any of the following events occur:
- Closing a trading position.
- Making a deposit.
- Completing a withdrawal.
- When an account is charged; for example, swap fees, conversion fees, etc.
Balance is unaffected by trading activities except when trading positions are closed, then it is updated by adding profits or deducting losses realized from the trade. Balance is equal to equity when there are no open positions. When there is an open position, equity changes with the market conditions while balance remains unchanged until the position is closed.
The Importance Of Equity in Forex Trading
Risk Management
Forex brokers are financial firms that provide software trading platforms where forex can be traded. Every broker defines its margin requirements, leverage, margin call, and stop out levels for a trading account. Proper knowledge of these terms can help a trader plan his trades carefully and optimize his risk management strategies.
Let us explain these concepts in detail.
Leverage and Margin
Margin is the deposit put forward by a trader in order to maintain a trade position. It is the amount of money required by the broker before the trader can open large trade positions. Leverage is the ratio of the deposit required from the trader to the market exposure offered by the broker. Both terms are related as follows:
Margin = (1/ Leverage) expressed as a percentage.
Free and used margin
Once a trade is opened, the broker locks the margin, and it becomes unavailable. This is known as ‘used margin’. The remaining part of the balance that is not tied to a trade is known as ‘Free margin. It can be used to open more positions.
Margin Level
The Margin Level is a percentage measure of the free margin or the amount of money available for opening new trades. Mathematically, it is the ratio of equity to the used margin; expressed as a percentage.
Margin Level = (Equity/used margin) X 100
If there are no open trades, the margin level is zero; but if the margin level is 100%, then there is no more free margin to open more positions.
Margin call
This is a notification issued by the broker to the forex trader to take an action; usually to close losing positions or add more funds to his account. Most brokers set their margin call at 100%, signifying that the used margin is equal to the equity. A margin call is automatically triggered once a losing account reaches the preset margin level.
Generally, forex traders dread a margin call because of its negative psychological effect on the trader. It simply means that you are losing money.
Stop-out level
This is the margin level at which the broker begins the liquidation of the trader’s account by closing losing positions. Assuming the stop-out level is at 50%; once the threshold is reached, the losing positions are closed one after the other until the margin level increases back to 100% and above.
Evaluating Trading Performance
Before opening a position, the trader can decide his position size, margin requirements, and set his profit target and risk tolerance. When trading is in progress, most trading platforms display the equity and balance of the trader’s account.
By monitoring the equity, a trader can assess the performance of his open positions. He can interfere by adjusting or closing out any position that has met his target profit. He can also adjust or close any losing trade.
How to Protect Your Equity in Forex Trading
Implementing Stop Loss Orders
A stop loss order is an order instructing the broker to buy or sell a currency pair when the price reaches a specified level. You can set the ‘stop loss’ and take profit price on the trading platform before or during a trade. Stop loss is used to close out a losing position to prevent further losses, while ‘take profit’ is used to close out a winning position to secure profits.
Embracing Diversification
Diversification is the strategy of investing in different assets to reduce the risks of volatility of one asset. In forex trading, you can diversify your portfolio by trading more than one currency pair, using different strategies on the same pair, or even investing in other assets offered by your broker. Some currency pairs are more volatile and move more pips per day than others.
Generally, you can diversify your portfolio by doing the following:
Allocating capital to different pairs
Investing little funds in the highly volatile pairs such as the exotic currency pairs, and investing more funds in the currency pairs with higher liquidity.
Choose your trading times
Forex is a 24/5 market with major trading hubs in New York, London, Sydney, and Tokyo. Some currency pairs behave differently when a particular session is active. It is better to experiment with your strategies at different trading times.
Not relying on one strategy
Always hone your trading strategy but be open to learning new strategies. Some strategies work better in certain market conditions and you may be losing trading opportunities if you have only one strategy.
Follow the market news
Many technical analysts believe that all they need to do is analyze the charts and derive their trading signals. But, fundamental data, market news, and even social media posts have been proven to have effects on the financial markets. A sudden economic change or breaking news can sway the markets and updated traders can take advantage.
Conclusion
Equity in forex trading is of utmost import to a forex trader because it is used in calculating margin levels, measuring trade performance, and managing risks. Balance refers to the total money in a trading account, while equity is the total value of the account, including floating profits or losses.
Equity informs a trader how his trades are doing and may prompt him into action to either secure his profits or curb his losses. Margin level is the ratio of equity to used margin and is used by the broker to determine when it is time for margin calls or stop out.
You must protect your equity while trading forex by using ‘stop loss’ and diversifying your portfolio.
FAQ
What Does Equity Mean When Trading?
Equity is the net aggregate of deposited funds and the potential profits or potential losses. It shows the floating balance; which indicates whether the trade is winning or losing.
How Do You Calculate Equity in Forex?
It is calculated by adding your deposited funds and the profits or losses from open transactions.
Equity = Account balance + floating profits
OR
Equity = Account balance – floating losses.
Is Equity Trading Risky?
Yes, trading the financial markets comes with a risk to your trading capital.
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