What is Equity in Forex Trading?

2024.01.18 2024.01.18
What is Equity in Forex and Why It Is Important

Oleg Tkachenkohttps://www.litefinance.org/blog/authors/oleg-tkachenko/

Balance, equity, margin, free margin, and level are key parameters characterizing the state of the account, potential profit or loss, the amount of free money for opening new trades, and the distance to stop out. The equity curve is the main visual tool that reflects the effectiveness of trading and trading strategy. It can be used to assess the stability of the trading system to market changes, the speed of recovery, the depth of drawdowns, and much more.

This article will help you understand the concept of equity and teach you how to calculate a sufficient level of equity, taking into account the floating financial result.

What is equity in Forex?

Equity in Forex is the total value of a trader’s account, taking into account both open positions and the available balance. This parameter reflects a trader’s current financial situation and shows what amount will remain on a trader’s balance sheet after closing all trades. The higher the equity, the more potential money a trader has for entering transactions. While trades are open, a trader does not own the amount of funds specified in the “Equity” parameter; when closed, this amount is displayed on the account balance.

A decrease in equity may result in a trader receiving a margin call, which is a requirement for additional collateral. A margin call means that a trader needs to deposit additional funds into the Forex account to cover losses. If the trader is unable to deposit additional funds, the broker will automatically close all positions.

Please note! In some sources, you can find the following definition: “Equity is the amount of free funds in a Forex trader’s account that can be used for trading.” This is not entirely true. Equity is the amount of money that will remain on the trader’s account after all trades are closed. The amount of free funds in the account at the time of open transactions is called free margin. It is calculated as the difference between equity and margin (money blocked by the broker for open transactions).

What is balance equity?

The balance equity in Forex trading is the value of the parameter when there are no open trades on the account. If there are no transactions, the equity value is equal to the balance. This is the money that a trader can withdraw from a trading account at any time. For open equity transactions, this parameter shows the possible amount of funds on the balance. If trades are not closed, the amount indicated in the equity cannot be withdrawn from the account.

What is floating equity?

The floating equity implies that the parameter dynamically changes simultaneously with the change in the current financial result across all open positions.

For example, there is 1000 USD on the account and there are no open transactions. This is your own free money that can be used in transactions. You open several positions. The “Balance” parameter remains unchanged (1000 USD), because the brokerage system does not yet know what profit or loss will be recorded. The system displays the value of the floating financial result in the “Equity” parameter. As soon as the price changes and, accordingly, the financial result changes, the value of the floating equity also changes. Once you close all trades, the Equity value moves to Balance.

If the total profit was 15 USD, then 1000 USD is displayed in the “Balance” column, and 1015 USD in the “Equity” column. Please note that what is important is the final financial result, not the result of an individual transaction. It takes into account the results of all transactions and the spread, which is subtracted at the time of opening a trading position.

What is negative equity?

A negative equity value means an amount that is less than the balance value. This is possible in two cases:

• The trade has just been opened. At the time of opening, the broker takes into account the spread, which is automatically displayed in the financial result. There is no profit yet, so the spread is shown as a loss. Accordingly, the negative equity value displays the balance amount reduced by the spread amount.

• There is a total loss on trades. For example, three open transactions bring profit, taking into account the spread of 5 USD each. The fourth trade brings a loss of 25 USD, taking into account the spread. The total loss will be 10 USD. With a balance of 1000 USD, the equity will be 990 USD.

Equity cannot be below zero, as this will mean a negative account balance. Almost all brokers protect themselves from a negative balance by automatically closing traders’ trades with a stop out when equity approaches zero.

Equity calculation

Below is the formula for calculating equity in Forex.

Equity = Balance + Profit on open positions – Loss on open positions, where:

• Balance is the amount of money a trader has deposited into the trading account, as well as any payments or bonuses received. Before starting trading, the balance is equal to the deposit made. After the start of trading, the balance is the remaining money on the deposit after all transactions are closed.

• Profit on open positions is the difference between the current price and the position opening price, taking into account the spread, multiplied by the number of contracts.

• Loss on open positions is the difference between the current price and the position opening price, taking into account the spread, multiplied by the number of contracts, with a minus sign.

If a trader does not have open positions, then the equity value is equal to the balance.

Why is it necessary to track equity?

• The rate of equity change shows the effectiveness and risks of the trading system. A strong drop in equity relative to the balance indicates risks, while rapid growth and decline indicate a large position volume and high volatility.

• When trading multiple instruments, the rate at which equity changes may indicate problems. For example, you opened five trades on five different charts. You can’t monitor all of them at the same time. Thus, if you see that the rate of equity change has increased not to your benefit, you will quickly lose money. So this is a reason to quickly review all charts for increased volatility and close or lock transactions ahead of schedule.

• Psychological effect. It’s nice to see equity growth. Conversely, a drop in equity pushes traders to quickly close losing positions.

Compare equity changes with previous periods to see progress. To do this, you will have to make frequent screenshots of the platform or record transactions since there is no history of equity changes (there is only a history of balance changes).

How to check the equity size in the LiteFinance terminal?

In the LiteFinance browser platform, you can see the equity size in the line under the price chart:

1. Go to a trading asset and open a trade.

2. The following information will be displayed in the bottom line under the price chart:

• “Assets, total” is equity, that is, the sum of the current balance taking into account profit or loss on open transactions.

• “Assets, used” is margin or amount of money blocked by the broker for transactions.

• “Available for operations” is a free margin. In other words, this is the amount that you can use to open future transactions.

The number in the “Assets, total” changes dynamically depending on changes in the financial result of open transactions.

How to check equity size in MetaTrader?

Equity is displayed in the “Terminal” window in MT4, and in the “Tools” window in MT5. There is practically no difference in the different names of windows. In MT4, the “Terminal” window is called up by a button on the toolbar.

In the “Terminal” window, in the “Trade” tab, there are five main parameters that display the balance status: balance, equity, margin, free margin and margin level. Let’s say you had a deposit of 5000 USD. You closed one trade at a loss, then opened two more trades that remain in the market.

1. Balance is the amount of money that is available before opening trades. It is equal to 4,999.54 USD. This means that before opening the two transactions that you see in the screenshot, you had an amount of 4,999.54 USD on deposit. With a deposit of 5000 USD, a transaction was opened and closed at a loss of 0.46 USD. This loss is shown on the balance sheet.

2. Equity is the deposit amount that you currently have, taking into account the total profit/loss on two open transactions:

• Your balance (the amount of funds in your account before opening a trade) is 4,999.54 USD.

• Your profit is shown in the very last column: 1.30 + 155.73 = 157.03 USD. In this case, both trades are profitable. If one of them were at a loss, the loss would be deducted from the profit of the other. The total result of transactions is taken into account.

• Commission amount: –0.44 – 43.70 = –44.14 USD.

• Equity = 4,999.54 + 157.03 – 44.14 = 5112.43 USD.

5112.43 USD will be on your balance when you close both current transactions.

What is the difference between equity and balance?

Balance is the amount of money in the account when there are no open trades. Funds or equity is a floating balance. In other words, this is the amount of money that will appear on the balance sheet after all transactions are closed. While transactions are open, the “Balance” will display the money at the time of opening transactions, and the “Funds” (equity) will display the balance amount and the current financial result.

Example 1. The balance is 1200 USD. There are no open trades. Balance = equity.

Example 2. The balance is 1200 USD. You open two trades. The first one brings a profit of 15 USD, and the second one brings a profit of 10 USD. The balance remains equal to 1200 USD, equity = 1200 + 15 + 10 = 1225 USD. If you close both trades, your balance will be 1225 USD.

Example 3. The balance is 1200 USD. You open two trades. The first brings a profit of 15 USD, and the second a loss of 10 USD. The balance remains equal to 1200 USD, equity = 1200 + 15 – 10 = 1205 USD. If you close both transactions, the balance will be equal to 1205 USD, that is, the amount of equity (amount of funds).

The spread amount is deducted from the floating profit/loss amount in any case.

What is the difference between funds and free margin?

When opening a transaction, the broker blocks part of the money. If the leverage is 1:1, then the blocking amount corresponds to the amount of the opened transaction. If a 100 USD trade is opened, the broker blocks 100 USD. If the leverage is 1:10, the broker blocks only 10 USD. The amount of blocked money is called margin.

Margin = ((Transaction volume in lots) × Contract size × rate) / Leverage

Free Margin = Equity (Funds) – Margin

Funds in Forex trading are money that will become yours if you close all transactions right now. Free margin is the part of your deposit that is not used in Forex trading and can be used, for example, to open other transactions. In other words, equity in Forex trading is the potential balance when all transactions are closed, and free margin is money that you can dispose of at your own discretion.

Example. When you have just replenished your account, the balance is equal to equity and free margin. For example, 5000 USD. You open two trades.

The total loss, including the fee, is displayed on the right in the last line. It is deducted from the trading balance, this is funds or equity. Since you currently have a loss, your equity is less than your balance.

When opening both transactions with a volume of 0.01 lot and 1 lot in total, the broker reserved 727.17 USD from your deposit. This means that at the moment you will not be able to open a transaction in the amount of 5000 USD, you no longer have this money, since there is a floating loss. But you will also not be able to enter a trade for the equity amount, because part of it is blocked by the broker.

If you close both trades, you will have 4951.69 USD left. You can use this amount in Forex trading further. But while transactions are open, the money available for further transactions is free margin. It is equal to 4951.69 – 727.17 = 4224.52 USD.

What level of funds should be in a Forex account?

The level of funds in foreign exchange trading should be high enough so that you can open new transactions as part of risk management. You determine the ratio of potential profit and risk for each transaction (stop level and transaction amount as a percentage of the amount of free funds in the account). The main goal is maximum profit with a risk level for all transactions of no more than 15% of the deposit amount. If your equity and balance gradually increase, then you have a sufficient level of funds.

The equity curve should ideally be smooth and steadily upward. This means static stability, guaranteeing that the trading system will continue to operate the same way in the future. Sharp drawdowns indicate that the strategy is not designed for force majeure or that a long stop loss was set. Drawdowns may indicate that the system is unstable and that a decline and a long recovery are projected in the long term.

Tips for maintaining high levels of funds

FX Equity is your money. Below are classic tips for maintaining a high level of funds:

• Follow risk management rules. A losing trade reduces your equity. If the loss goes beyond what is expected by risk management, close the trade.

• Open trades based on analysis. Don’t completely trust your intuition and don’t follow the crowd.

• Test your trading strategy before launching on a real account. After testing on a demo account, the deposit curve will show the level you can achieve in the real market. If it or the speed of achieving the result does not suit you, change the settings of the indicators and the indicators themselves, and optimize the trading strategy until you get an optimal result.

• Watch your emotions. Don’t try to open trades after the majority of traders, regretting the missed opportunity. Don’t rely on the Martingale strategy and quick results. With a high probability they will be negative. Do not open transactions in a state of excitement, euphoria, or despair. Rely only on analysis.

• Avoid stop-out levels. The broker will automatically close profitable transactions as well. It’s better to close unprofitable positions yourself.

Never risk your entire capital on one trade. Always leave a fiscal cushion in case the trade doesn’t go according to plan.

Equity curve and trading strategies

The equity indicator displayed in the trading platform is an information tool that is used to monitor the current situation and make a short-term forecast. FX Equity shows you how much money you may have after closing your trades. Based on this, you can make a short-term decision to open additional trades or reduce your risk level. However, this is not enough for a more detailed analysis.

An equity curve or deposit curve is a chart that shows the change in balance over time. It is calculated based on all transactions that a trader has made since opening the account.

The equity curve can be ascending or descending. An ascending equity curve indicates income, and a descending equity curve indicates losses. If the equity curve falls to zero below the starting balance, a stop-out occurs.

The equity curve can be smooth or have sharp drops. A smooth equity curve means that the trader is consistently making or losing money. Sharp changes indicate high-risk transactions that can lead to losses.

This is an example of a not very successful backtest, from which the following conclusions can be drawn:

• The beginning was successful. The trade was opened in the right direction, the equity parameter increased, but then the profit was locked in. The trend reversed, and the equity began to decline. It was decided to close a profitable trade by opening a trade in the opposite direction. The first corner of the broken balance curve (sections 1-2) shows profit taking.

• The decision turned out to be wrong. The price reversed in the original direction, and the equity continued to fall. The position was again closed with a subsequent reversal. The second corner (section 2-3) indicates the position being closed.

• Reversing the position again turned out to be a mistake. Position volumes increased sharply due to confidence in the trend. This can be seen on the horizontal scale. In the first segment, the equity curve moved at small angles; in the second segment, there was a sharp drop in the balance (sections 3-4).

• In the next section, a trade in the right direction was opened. But as soon as an equity downtrend emerged again, the trade was closed, and the balance was locked in (sections 4-5).

• Locking is visible in the last section. Two transactions are opened in opposite directions with the same volume. The exit from the locking was made in parts, as a result of which it was possible to recoup the cost of the spread. The section of the balance curve is almost horizontal (5-6).

Please note that the equity parameter takes into account open transactions. The equity curve (balance curve) is built only on closed positions. That is, the parameter does not take into account price fluctuations in both directions for open transactions.

The type of strategy used can be determined by the shape of the equity curve. For example, if you see frequent deep, sharp drawdowns with quick recoveries, it is likely that a Martingale strategy was used. A series of unprofitable trades with an increase in the volume of the position is the reason for the drawdown. The next double trade leads to a quick recovery.

Conclusion

• Equity reflects the current financial state of the trading account, taking into account both realized and unrealized profits and losses.

• Equity is equal to the balance (the amount of money in the account available for withdrawal at any time), provided there are no open transactions.

• Balance, equity, margin, free margin, and level are the main parameters for monitoring your account status. All these parameters are displayed online on most platforms in a separate window.

• To maintain equity at the proper level, it is necessary to minimize risks, avoid deep drawdowns, and trade mainly with trends.

• Equity curve is a deposit curve showing the nature of changes in funds on the balance sheet over a fixed period. This is one of the key parameters for assessing the effectiveness of a trading system.

• Testing a strategy is a mandatory step before using it on a real account.

Try to periodically close some transactions so that the amount of equity is recorded on the balance sheet.