There are many things that ought to be part of your checklist in the forex market. Things that you actually need to tick off one by one to make sure that you are standing on solid ground and not on thin ice.
One of these important factors is equity. Equity plays a serious role in the process of trading and also in the outcome of trading and how much profits you will ultimately make.
Equity is basically the money that you have for trading – i.e. the money in your trading account. But there is much more than that. Equity can take other definitions while being applied to trading. Let’s find out together what equity exactly is and why it is important in forex trading.
What Is Equity in the Forex Market?
As was mentioned above, equity in forex refers to the totality of your assets that exist in your trading account. So the total liquidated assets that you have put in your account make up your equity.
Of course you do not keep your equity as it is. You use it for trading. So when you take that equity in a position or various positions, then the trading platform that you are using might use other methods of calculations to find your total equity.
There are different factors that are involved in equity. Let’s find out what they are.
How Is Margin Related to Equity?
The relationship of margin to equity has to do with leverage trading. In order to find out exactly how much equity or initial assets you need to put up in your trading account, you need to think whether you want to use leverage or not. And if so, what is the rate of leverage you are going for?
Now you need to understand the risks that are involved with leverage trading. Leverage trading allows you to trade with multiple times the initial amount, i.e. equity, that you have in your account. It is similar to money that you borrow from the broker to trade with.
The biggest risk associated with leverage trading is of course the fact that your trades with leverage might go bad and you might lose more than what you have. But that would mean the broker would lose money. And that just cannot happen. The house always wins, remember?
So to protect the money that they lend to traders, they specify an amount known as margin, which is basically the collateral that they can use as initial down payment to get the leverage.
Therefore, depending on whether you want to use leverage trading and how much margin the broker wants, you need to adjust the equity in your account.
Equity is among the most important factors for receiving leverage from your forex broker. Which means the more money you put in your account as part of the initial deposit, the higher chance of receiving a better rate of leverage.
Is Account Balance the Same as Equity?
The next idea that is usually tied closely to the notion of equity is balance. Are they the same thing? Well, not exactly. Balance refers to the initial state of your account when you deposit the equity into it.
Unlike equity, account balance is not going to change or vary based on the positions that the trader opens. In fact, the only way account balance is affected by trading is through the positions that are closed.
So when the positions are finalized, it could make a change in the amount of account balance.
How Does Profit or Loss Change Equity?
When you finally close your positions, there are two possible outcomes. Either you have done your due diligence enough and your position ends in profit. Or chance has not been on your side and your position ends in loss. What does that do to your equity?
When all the open positions are close, the potential profits or losses are actualized. When that happens, we can have the real amount of equity in forex. The amount of profits that are added to the initial equity or the amount of losses that are deducted from that initial amount.
The Importance of Equity in Forex Trading
The importance of equity in forex cannot be overlooked. We already mentioned many factors that are directly tied to equity. This includes margin and leverage trading. But since this matter is truly significant, let’s take another stab at it and look at another important relationship between equity and margin.
When you have open positions while using leverage for trading, you have put up a percentage or all of your equity as margin. Remember that margin acts as the collateral that you need to put up in order to receive the leverage.
When things work out well, and your position ends in profits, then you will not lose your margin. Not only that, your potential profits will be added to your account when the positions are closed, which means your equity will increase in the end.
But unfortunately that is not what happens all the time. Sometimes, because of a myriad of different reasons, your positions might go into loss. When that happens, the money that is lost is not deducted from the leverage that the broker has provided for you. That goes without saying. The money that is lost first is your margin.
However, if the position moves away from the loss territory, then your margin will not be lost as much, which ultimately means that your equity can go over the amount of margin.
But as mentioned before, if you lose too much, then your equity will not be able to support the amount of margin. What happens then?
If your equity is not able to support the margin, it means you will no longer be able to open any positions. But not only that, if the amount of margin far exceeds the amount of equity, then your position will be closed altogether by the forex broker.
However, before that you will receive a margin call. A margin call is basically a notice by the forex broker that as the trader you need to increase your equity to meet the required amount of margin.
A truly significant factor that must be kept under constant monitoring by the trader is the concept of equity. Equity refers to the total amount of assets that you deposit into your account and what is left after obtaining profits or sustaining losses. You always need to monitor this amount because it should be at an ideal level that can fully support all your trades and especially so if you are using leverage trading and need to support your margin levels.