Any beginning trader will be able to show off his brokers leverage level – the amount by which a broker increases the position size relative to the client’s actual investment. The other side of that is margin – how much you need to maintain as free equity in order to maintain your positions open.
Trading on margin is somewhat like taking out a mortgage – the bank gives you funds to purchase an apartment, but you need to set aside a certain sum in collateral. Here, if you decide to open a $1,000 position on – say – oil with a broker offering 20:1 leverage, you will be required to set aside 1/20th of the position’s value in the required margin (5% x 1,000 = $50).
This money is not deducted from your account until you close your position!
Instead, you set aside your $50 required margin, but then another form of margin enters play: USED margin. That is you required margin plus extra funds to cover potential losses.
Now, take close notice: just as your profits will be magnified thanks to the margin, so are your losses. If the value of your position increases by 10%, it will increase by 10% of the POSITION value, not your required margin, i.e. 10% of $1,000 (=$100), not 10% of $50 (=$5).
Conversely, if your position loses that same 10%, you will need to set aside used margin of the leveraged value of the position, i.e. $100. Suddenly your equity has dropped far beyond your initial investment.
To ensure you do not enter a negative balance in such a volatile environment, your broker is required by law to send you a margin warning what a specified level and then close off positions to prevent a negative balance.
Besides always maintaining a healthy distance between your free and used margin, therefore, it is important to set up stop-loss orders ahead of time that will close positions at a level of loss you are prepared to suffer. These should be placed at a safe ratio vis-à-vis your take-profit order. Beginners will usually opt for a 1:3 ratio – say $1 potential loss for every $3 potential profit. Nobody opens an order without a stop-loss.