Explaining a Trading Account
One of the most important decisions a trader must take, besides choosing the Forex broker to trade with, is the type of the trading account. There are many account types that are offered by various brokers, and they provide an info about the way the brokerage house is organized. Conditions offered in a trading account differ based on the type of the broker: dealing desk brokers offer different conditions than non-dealing desk ones, and ECN (Electronic Communication Network) or STP (Straight Through Processing) have other types of trading accounts. However, the way to deal with a trading account is the same, as there are a few things to consider. Because the most popular trading platform is the MetaTrader 4, we’re going to use it for showing what are the things to know in a trading account. The most important ones are to be found below.
Elements Part of a Trading Account
There are three elements part of any trading account, no matter the trading platform. These are:
– Free Margin
The balance of a trading account represents the total value of it, without considering the open trades that might exist. If there is no open trade, all three elements, balance, equity and the free margin will show the same value, meaning the amount the account is funded with. However, after opening a trade, things are becoming a bit more difficult to interpret. While the balance tab will always show the same value, except a trade is opened and closed, the other elements will change. This has a terrible psychological effect on traders as there is a strong tendency for the balance to be the one considered as showing the value of a trading account. That is totally wrong! The one thing that matter for a trading account, or the one thing that shows the true state of it, is the equity. So, if anything, traders should focus on increasing the equity, not the balance of a trading account.
Equity shows the real value of a trading account at any moment in time, no matter if there are positions opened or not. Even the number of the opened positions is not important, as the equity value is adjusting automatically, based on that number and the way the positions are fluctuating in the market. Typically, the equity in a trading account shows the profit that was not yet booked (in this case, equity value is bigger than the balance value) or the loss that was not yet marked (in this case, equity is smaller than balance). As a rule of thumb, the bigger the equity, the more profitable the trading account is.
Before opening any trade, the free margin is showing the amount in a trading account that can be used for trading. If a trade is open, that free margin will show the difference between the total amount minus the margin blocked in a trade. Depending on the volume and the currency pair traded, the margin needed for the trade can vary. When there is, no free margin left, there is not possible to open any new trade anymore. To free margin, either some open trades must be closed, or new funds must be deposited in the trading account. In a way, the free margin is a reality check for the trading account, as the more it decreases, the riskier trading becomes and chances for the account to be blown are growing. The image you can see above is part of a demo trading account and shows how the account is looking like before opening a trade. Or, how the account is looking right after it is funded. The moment a trade is opened, some other elements appear, as it can be seen in the image below. To exemplify, I sold an EURUSD position, to see what other elements must be considered.
Entry, Stop Loss and Take Profit Level
These are the three levels that define any trade. It is mandatory to have a stop loss (this means the level at which the trade or analysis doesn’t make sense anymore) or a take profit (this is the target or level the price must reach for the analysis to be right) order for any trade. This shows that a plan was in place and eliminates the risk of the account being depleted. Risk management and money management are key in growing the equity of a trading account. There is the possibility that those lines/levels are not shown on a chart, and this is strongly recommended if more trades are open on the same currency pair at any one time. Otherwise, the chart becomes too crowded.
Other Things to Interpret
The moment a trade is open, there are other things to consider. The trade that I mentioned above was a short EURUSD trade, the position size or volume is 0.5 (half a standard lot), and the direction is short (sell). There is a ticker associated with every trade that is being taken. The idea behind this is that traders can go and track down each trade based on that ticker number (Order, the first column on the image above). Moreover, the date appears as well, stating both the calendar date and the time the trade was opened. Stop loss and take profit are part of any reporting, as well as the entry level. A short description of the trade listed above will look like this: we went short at market 0.5 lots EURUSD at 1.07458 with 1.0800 stop loss and 1.06450 take profit. If the stop loss is reached, the trade ends with a loss that will be deducted from the balance of the trading account. If on the other hand, the take profit is hit, the balance will increase with the corresponding amount. In both cases, though, the margin blocked for the trade will be released and become free margin. The commission tab shows the broker’s fee for opening this trade. This increases or decreases with the volume traded, and it is always deducted from the trading account at the very moment a trade is open. Attention: it is deducted from the equity, not balance. Again, equity reflects the true state of a trading account. The swap tab will show a positive or negative amount that will be added or deducted from, again, the equity value, at the end of each trading day. When positions are rolled over into the next trading day, the interest rate differential between the two currencies that make the currency pair will result in a positive or negative swap. Finally, the margin level shows the margin percentage still available for taking new trades. It is just another tool for traders to consider when interpreting the state of a trading account. All the elements listed in this article are part of the state of the trading account and, more importantly, are used in setting the risk for the account. A sound money management plan must always consider the state of the trading account, no matter the trading strategy used.
Recommended Further Readings
- Forex Trading – Explaining the Concept
– What is Forex trading, generalities about trading the currency market.
- Why Trading Forex?
– Advantages and disadvantages of trading the currency market, what are trader’s expectations and what is a realistic approach to follow
- What is a Forex Broker and Types of Brokerage houses
– Explaining what a Forex broker is and does, how the business should be organized, and how many types of Forex brokers exist.
- Financial Products to Trade
– Different categories of financial products that a Forex Broker is offering for the retail clients, starting with the classical currency pairs, and continuing with commodities, CFD’s, indexes, etc.
- Explaining Commissions in Forex Trading
– What type of Forex trading accounts are subject to paying commissions, what does it means and is this a good or a bad thing?
- Opening a Live Trading Account
– Steps to open a live trading account with a Forex broker, starting with the time taken for the whole process, documentation to be sent, verification process, trading platforms to download, etc.
- Forex Trading – Explaining the Concept
Other Educational Materials
- Explaining the global pattern of current account imbalances. Gruber, J. W., & Kamin, S. B. (2007). Journal of international money and Finance, 26(4), 500-522.
- Predicting and explaining the adoption of online trading: An empirical study in Taiwan. Lee MC. Decision Support Systems. 2009 May 31;47(2):133-42.