CFDs are complex instruments and come with a high risk of losing money rapidly due to leverage. Between 74-89% of retail investor accounts lose money when trading CFDs. You should consider whether you understand how CFDs work and whether you can afford to take the high risk of losing your money.
March 10, 2019
The essential elements of a trading account: balance, equity and margin.
More and more people come to trade financial markets every day. Because the Internet penetrates deeper into all corners of the world, everybody has access to financial markets.
Brokers spotted the opportunity. Since online trading became a reality, the competition among brokerage houses increased exponentially.
As such, brokers tried to differentiate themselves by adding something new to their offer. Some introduced new markets to trade. Others, new types of trading accounts.
Depending on the type of retail trader targeted, the broker’s offer takes various shapes. One thing, though, all brokers have in common: regardless of the type of the trading account, its elements remain the same.
The traders must know how to make the most of the elements of a trading account. However, perhaps it seems so easy, many traders fail at doing so.
All of them play a crucial role in understanding the value of the account. And, more importantly, what traders can and cannot do.
Yet, one stands off the crowd, as it offers the most relevant information to the trader. That’s the equity of a trading account.
Imagine you want to start trading. You already went through the ups and downs of trading a demo account and feel ready for taking the big leap.
First, you need to choose the type of the trading account. Depending on the trading style (scalping, swing trading, investing), some accounts are better than other ones.
Funding the account is the next step. One can choose from the various methods available, and, at the end of the process, the desired amount is credited to the account.
At this point in time, assuming no open positions, the balance and the equity will show the same amount, the deposited one. However, things are about to change from the moment trading begins.
The most crucial thing to know about the balance is that it never changes unless an open trade is closed. Either reaching the take-profit level or the stop-loss, what matters is that the trade is not active anymore.
The balance reflects the outcome of the trade by shrinking or increasing accordingly. But here comes the tricky part.
Because human nature makes traders keeping losing trades open longer than winning ones, the balance is almost always bigger than the equity. As a side note, the equity reflects the true value of the trading account. That is the current value of the account, considering all the open positions.
For this reason, there’s a strong tendency for traders (mostly inexperienced ones) to focus on the balance, rather than on what the equity of the trading account shows. However, that’s the biggest mistakes of them all.
The balance, as many retail traders find out, misleads traders. It gives the impression that there are enough funds in the account, when, in fact, the equity might signal something completely different.
If there’s one element to focus on, that’s the equity. It offers the true picture, of the account, and, ideally, it should always exceed the amount shown in the balance.
Yet, that’s not possible. During the lifetime of a trading account, most of the time it’ll have a negative yield. It means, effectively, that the equity will almost always be smaller than the balance.
But that’s O.K., as long as the focus remains with the equity. Some traders use the equity as the basis for their money management system.
For instance, if the equity drops below a certain level (typically a percentage), they start cutting positions. This way, the account’s equity won’t fall uncontrollably, avoiding possible margin calls.
The margin is sort of collateral. The brokerage house blocks it, and its size depends on the currency pair traded.
And, of course, on the volume. The bigger the volume traded, the bigger the margin needed.
At the closing of the trade, the margin is released so that traders can use it for other opportunities.
The trading account shows the margin blocked by the open trades. It is deducted from, you guessed, the equity, not the balance of the account.
Also, traders can see the free or available margin. This is the amount available to invest.
Last but not least, the MT4 platform also offers information regarding the margin level. Needless to say, the bigger the available margin, the better. Or, the bigger the margin level, the better.
As a rule of thumb, try keeping the free margin always bigger than the margin blocked in open trades. This gives flexibility when the positions turn against the desired direction.
On top of that, the trader can take advantage of any new possible trades. Thus, the opportunity cost doesn’t exist.
As a final word, the elements of a trading account play a vital role in day-to-day trading activities. Even though it doesn’t seem at first, understanding their purpose helps traders succeed in the game of speculation.
The ultimate purpose of the elements of a trading account is to help traders protect the account. Statistics tell us that retail traders struggle in the long run to maintain their profitability.
For this reason, building a money management system based on the equity of a trading account is far more important than the actual trading strategy. As always, money management is the one that makes a difference between how fast the account grows, or how quick it shrinks.
The ones able to successfully combine money management with the elements of a trading account stand a better chance to face adverse market conditions. And, make no mistake, adverse conditions exist with every trade.
The secret is how to “handle the fire” when the market goes against the desired direction. For that, a proper starting point is to understand the relationship between the balance, equity, and margin of a trading account.