What is equity in forex?
What's the first thing that comes to your mind when you hear the word "Equity"?
"Seems like an Einstein's equation to me".
Well, wrong answer!
Equity is much simpler than any complex equation.
Let's try to find what exactly is equity in forex.
What is equity in forex?
Simply said, equity is the total amount of money in your trading account. When you look at your trading platform on your screen, equity is the current worth of the account, and it fluctuates with each tick.
It is the total of your account balance and all floating unrealized profits or losses from open positions.
As the value of your existing trades rises or falls, so does the value of your equity.
Calculating equity
If you have no open positions, your equity is equal to your balance.
Assume you deposit $1,000 into your trading account.
Because you haven't yet opened any trades, your balance and equity are both the same.
If you have any open position, your equity is the total of your account balance and the floating profit/loss of your account.
Equity = Account Balance + Unrealized Profits or Losses
For example, you deposit $1,000 in your trading account and go long on GBP/USD.
Price moves immediately against you, and your trade shows a floating loss of $50.
Equity = account Balance + Floating Profits or Losses
$950 = $1,000 + (-$50)
The equity in your account is now $950.
On the other hand, if the price goes in your favourable direction, and your floating profit becomes 50, then your equity is:
Equity = Account Balance + Floating Profits (or Losses)
$1,100 = $1,000 + $50
The equity in your account is now $1,100.
Factors affecting equity
Many things affect the value of your equity, so let's take a look at them:
Account Balance
As mentioned earlier, If you have no active positions in the market, your account balance equals your total equity. When you open and hold a new trade, the distinction between these two concepts becomes clear. In this instance, your account balance will remain the same as it was before opening the trade, but your equity will be affected by the trade's unrealized profit or loss.
If the position suffers an unrealized loss, the amount of the unrealized loss will be deducted from your equity. If your position is in the positive region, i.e. you have an unrealized profit, that amount will be added to your equity.
Your account balance will only change once all open trades are closed, and it will then be equal to your equity. That is, all unrealized profits and losses will be recognized and added to your equity as well as your account balance.
Unrealized Profit/Loss
You're probably aware that your open positions have an impact on the value of your equity due to unrealized profits or losses. Unrealized profits and losses are realized when open positions are closed, and your account balance changes accordingly. Many trades will occasionally lose money before turning a profit.
While you must have faith in your analysis and trading method, most profitable traders are impatient with losing positions. They trimmed their losses while leaving their gains alone. This is the exact opposite of the attitude taken by losing traders or newbies, who hope and wait for their lost trades to turn profitable while closing their lucrative positions too soon. Take care of this minor detail if you wish to increase your equity.
Margin and Leverage
Margin and leverage are the next concepts that have an impact on your equity. The FX market is extremely leveraged. This means that you can control a lot larger position size with a modest amount of money. When you open a leveraged position, a portion of your account size is set aside as security for the position, which is known as the margin.
For example, if you have a 100:1 leverage on your account, you just need $1,000 as a margin to create a $100,000 position.
Assume your account balance is $10,000. If you open that position, your balance will remain the same ($10,000), your trading margin will be $1,000, and your free margin will be $9,000.
The position's unrealized profit or loss will have an impact on your equity. In other words, your equity, as well as your free margin, will fluctuate in response to changes in the exchange rate of the pair.
While your margin remains constant, your free margin rises with unrealized profits and falls with unrealized losses. When all of this is added together, your equity will be equal to:
Equity = Margin + Free Margin
Or,
Equity = balance + unrealized profits/losses
Margin Level
Many trading platforms will also show your margin level, which is just your equity divided by your margin into percentage terms. In the following example, if our position is at breakeven (no unrealized profits or losses), our margin level would be $10,000 / $1,000 x 100 = 1,000 percent.
Margin Call
When your leveraged position doesn't go in your favor and your free margin falls to zero, you receive a margin call. This means you have no capital to sustain negative price changes, and your broker will cancel your positions automatically to safeguard its (and your) capital. After receiving a margin call, the only thing left in your trading account is the initial margin used for opening the position.
Margin calls are a trader's worst fear. Fortunately, there are efficient ways to prevent them from occurring. First, you must grasp all of the topics discussed in this guide and how they are related. Second, always be aware of the risks associated with leverage trading. If you open too many leveraged positions, then your free margin is insufficient to survive even little losses. So, you will almost certainly face a margin call.
Pro tips about equity
Don't let the numbers get out of hand – always set stop-losses and ensure that the total of all unrealized losses (i.e., a scenario in which all of your stop-losses are hit) never exceeds your free margin. This way, you may be confident that you have adequate cash to cover any losses on your open positions.
If the market turns around and there is a drop in the number of losses, more margin will free up, and the equity will quickly jump over the margin. In addition, the size of the new trade will be determined by how much the forex equity exceeds the margin.
Another possibility is that if the market continues to move against you, the equity will fall to the point where it is less than the margin, making it practically hard to fund the open trades.
Naturally, you must liquidate the losing trades in order to balance the equation and protect the broker's leverage capital.
Also, your broker might set a percentage restriction that creates the threshold value for this event to occur. Suppose it sets the margin level to 10%. In that case, it means that when the margin level reaches 10% (that is when the equity is 10% of the margin), the broker will automatically close off losing positions, starting with the largest position.
Why is equity important?
FX trading equity is crucial since it allows traders to determine whether or not they can initiate a new position.
Assume you have a highly profitable trade open, but it is moving slowly. You know you have enough money in your account to make a new trade since your equity tells you so. As a result, you open new trade and transfer the freshly obtained equity from your previous trade to your new trade. If you made the right choice, your profits would soar.
When the initial trade is unprofitable, the equity informs the trader that there isn't as much accessible on his or her balance to begin a new trade.
As a result, it acts as a warning indication to simply close one losing position as soon as possible before beginning a new one.
Does equity have an impact on me as a trader?
Technically, yes. You can't open a new trade if you don't have enough forex equity because your balance won't allow it. The more trades you can open with higher equity, the more profits you generate in forex.
Equity in forex is what allows you to grow as a trader, raise the number of trades you have open, and raise the overall profits you earn. It would be impossible to trade without it.
Pros
- It helps you in managing unrealized profit and losses.
- It helps you in your risk management strategies.
Cons
- You can't open a position if there is no equity.
Bottom line
All forex traders must understand how equity, balance, unrealized profits and losses, margin, and leverage work. This way, you'll be able to take reasonable risks and avoid the dreaded margin call. Take care when initiating leveraged positions, limit your free margin, don't risk too much of your account balance, and watch your trading equity increase with a solid trading plan.
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