A trading account reflects an investor’s ability to perform. Whether it succeeds or not, it reveals what works and what doesn’t work in a trading strategy or approach.
Many investors confuse ‘trading platform’ with ‘trading account’, which is quite a big mistake. The trading platform is the medium used to grow the trading account, and the account reflects the investor’s individual performance while trading on the financial market.
This article is not about currency pairs, spreads, swaps, commissions, and everything a trader deals with when buying or selling currencies. Instead, it is about the three elements that govern every trading account: balance, equity, and margin.
When funds are first deposited into a trading account, the amount is immediately added to the balance. It remains unchanged, even if an investor buys or sells something. It will only change when the position is closed. Hence, the balance can confuse investors as it doesn’t reflect the sum available for trading. Instead, it shows the “paper value” of the trading account.
Now, this is the real deal. While the balance remains unchanged until a trade is closed, the equity changes from the instant a trade begins. It reflects the future trading potential, and it’ll change with how the open trade performs; increase when the trade goes in the right direction, decrease when not. For this reason, an investor’s focus should be on the equity, and not on the balance. The equity shows real buying or selling power, while the balance only shows the potential. The balance presents the best-case scenario; however, the equity shows the real amount, leaving no room for a biased approach.
Because the main enemy in Forex and financial market trading, is generally the trader themselves, it is essential to understand that fooling yourself leads to false expectations. Equity ensures the trader focuses on the correct element of the trading account.
Forex trading needs leverage for the retail trader to be able to move significant amounts in the interbank markets. The higher the leverage, the lower the margin needed to back up a trade.
When opening a trade, the broker blocks a margin corresponding to the leverage of the trading account and the volume traded. If there is no margin left, it means either the trader opened too many trades and has no capital left to open more, or, the market went against the intended direction and the trader must close some of their open positions. If not, they will receive a margin call. Therefore, the free margin in a trading account is the difference between the equity and the blocked margin. Hence, it’ll increase or decrease depending on how the open trades perform, reflecting the power of buying or selling that still exists in the trading account.
It is clear that, once again, equity plays a critical role and is shown to be the most crucial element in a trading account. The ability to deal with its rise and fall will determine the performance of the overall trading account.
- Balance misleads traders as it mostly refers to paper capital.
- Equity is the real amount.
- Margin depends on leverage.
- Free margin is the difference between equity and blocked margin, and indicates the buying or selling power of a trading account.