What is Equity?
  • What is Equity?

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    In Forex, the concept of equity has to be looked at in terms of when trades are open and also in terms of when there are no active positions in the market. 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 on the MT4 platform is called the 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.

    Equity in forex therefore refers to the total value of a trader’s account, when any open positions have been factored into the equation. For instance, a look at the MT4 charts will give some idea about what equity in forex really stands for. After a trade is opened, a number of figures are listed on the MT4 platform, at the trade terminal window. The trade terminal window shows the following parameters:

    a) Balance: this refers to the total starting balance in the trader’s account. It is not affected by any open positions until when all active trade positions are closed.

    b) Trading Equity: This refers to the true amount of money that a trader will be left with when all active positions are closed. The trader’s account balance is made up of the equity and the unrealized profit or loss in active positions.

    c) Unrealized profit/loss: This is the profit or loss in financial terms that a trader’s account accrues from all open positions. They are referred to as unrealized because they are in actual fact, not true profits or losses. Their presence only indicates the state of the positions in the market, and because they are not yet added to the account, they remain unrealized and are subject to change. They only become realized profits or losses when the positions are closed, and this is the only time that they can be added or removed from the trader’s account. At this stage, no change can occur to a trader’s profit or loss.

    d) Margin: The degree of collateral that the trader must put up for the trade in order to use the leverage provided by the broker. Remember from some of our previous discussions that forex is a highly leveraged market, allowing traders to put up a sum of money (the margin) in order to control larger trades.

    It therefore follows from all what has been said above that the trader’s equity is a function of the degree of profit or loss that the account sustains from open or closed positions. The equity changes as the unrealized profits/losses in active positions change. When the positions are closed and the profits are now added (or losses removed) from the account balance, then the trader’s equity is now known.

    The concepts of account balance, equity, leverage and margin are intertwined. A trader must know how they all connect so as to preserve capital when trading. Traders who suffer the dreaded margin call are those traders who do not understand the inter-relationship between equity, leverage, margin and the account balance. As such, they open positions in a way that does not create balance between the trading equity, leverage and margin requirements and the account capital.

    Equity is also known as the leverage factor. Generally equity on the forex account should be higher than the margin used for trades. The equity or leverage factor used for the trade can go a long way to determine the profits made or losses sustained on the account. This is why it is very important for traders to understand how to use equity to create a balance between the risk and reward of a trade, and the role of leverage in all this.

    Let us use some examples to explain the relevance and uses of equity to the forex trader.

    Uses of Equity
    Take a look at the terminal window on the MT4 platform when there are active positions in the market.

    The Balance in the account will change only when the trader closes the active position(s). The profit/loss from such trades will be added to/deducted from the initial account balance and the new balance will be displayed on the terminal window.

    Assuming there is a balance of $5000 in the account and there are active trades that total $100 in unrealized/floating profit or loss, then

    Balance – Floating Profit/Loss = Equity
    $10,000 – $100 = $10,100

    Margin = $2,859.52
    (trade volume (in money terms) x price of the asset) / 100 = $2,860.00

    Equity – Margin = Free Margin
    $10,050 – $2,859.52 (margin) = $7,190.48

    (Equity / Margin) x 100 = Margin Level
    ($10,050 / $2,859.52) x 100 = 351.46%

    Also take a look at the MT4 interface when there are no active positions in the market:
    (Diagram)
    Here, account equity = free margin = account balance

    Take a look at where the Equity on the account is listed. It can be seen clearly that the equity is the money a trader has in his account, plus or minus the money that the trader has when all open positions are wound up. In other words, Equity is the account balance plus the floating or unrealized profit/loss on any open positions.

    For example, if the trader had $3,000 in his trading account and there were two open trades that were collectively in profits to the tune of $400, the equity in the account would be $3,400 when both trades are closed.

    If there are two open positions which are $300 in profit, and one open position that is $600 in a loss position (i.e. -$600), the account equity would display – $300. When the trades are closed, the $600 would be removed from the account balance and this would display as $4,700. In this case with a closed position, the equity would be the same as the account balance.

    Open position: Equity = Balance + Floating Profit/Loss

    Closed position: Equity = account balance

    And for example when you have some open positions and they are $1,500 in profit in total, then your account equity is your account balance plus $1,500. If your positions were $1,500 in loss, then your account equity would be your account balance minus $1,500.

    Let us now examine the relationship between equity and free margin.

    Equity and Free Margin
    How do equity and free margin relate with each other? Free margin is defined as the difference between the equity and the margin of all active positions.

    Free Margin = Equity – Margin

    When there are no active positions in the market, no margin is required from the trader as trade collateral so nothing is taken from the account for this purpose. In this state, the account balance will be the same as the account equity and free margin.

    The moment a trade is initiated in the market, the situation changes. For instance, if a trader with a $5000 account opens positions and submits a margin of $450 for the trade, and the total of all open positions is $200 in profit,

    Equity = $5,000 + $200 = $5,200

    The Free Margin = $5,200 – $450 = $4,750

    This leads to another calculation known as the Margin level, which is:

    Margin Level = (Equity / Margin) x 100

    The margin level is used by brokers to work out if traders are able to enter new trades or not. Some of you here who have tried trading with low capital on MT4 and get the message “NOT ENOUGH MONEY” will be familiar with this concept.

    The margin level is set at a percentage limit called the margin call level. When the Equity = Margin, no new positions can be opened.

    For instance, if a $5,000 account holder who uses $500 as margin incurs a running loss of $4500, the equity (5,000 – 4,500) would have equaled the margin, meaning that the trader has no more margin to support new positions.

    If the market experiences a turnaround and there is a reduction in the degree of losses, then more margin is freed up and the equity will once again surpass the margin. The size of the new trade will then be determined by the extent to which the equity surpasses the margin.

    If the market keeps moving against the trader, then the equity will drop to a level where it will be less than the margin, making it impossible to sustain the open trades. Naturally, the losing positions must be closed to balance out the equation and protect the broker’s leverage capital. A broker can set the percentage limit that forms the threshold value for this event to occur. If a broker sets the margin level to 10%, it means that when the margin level approaches 10% (i.e when equity is 10% of margin), the broker will automatically close out losing positions, starting from the one with the largest floating loss. If after the closing of a position with the largest floating loss, the market continues to move against the trader in such a way that the broker’s capital is once again threatened, the broker will take the same course of action to close out any position(s) with the largest unrealized losses. Of course if the trader deposits more capital as to increase the balance on the account using an instant deposit means of transaction (e.g. credit card), then money can be taken from the new account balance to add to the margin, thus keeping the positions open.

    Understanding the role of equity in all this will help a trader to structure his trading activity so as to avoid taking on too much risk and risk getting the account margin called.

    The important lesson here, is that the equity must be kept at levels that are high enough so that at no point in time does the account suffer when losing trades are incurred. This can be by either increasing account equity (account capital) or by using proper leverage/margin requirements commiserate with the account size.

    Attention!
    The author’s views are entirely his or her own.

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