Leverage and Margin
The primary aim of every forex trader is to capitalize on the market movements by predicting the correct exchange rate direction at any given time. But, the price movements are very small; hence, they are measured in pips. For most currency pairs, a pip is a change of $0.0001 in the exchange rate. This means that a trader needs very huge trading capital in order to make significant profits.
Example 1: Richard has about $100,000 in his trading account. He opens a ‘buy’ position on 1 mini lot of the EURUSD at an ask price of 1.10289 and closes the order at 1.10689. (1 mini lot = 10,000 units of currency)
Since it a buy position and the prices went up, he made a profit.
Pips gained = 1.10689 – 1.10289 = 0.00400 = 40 pips
To open this position, he needs 10,000 X 1.10289 = $11,028.90
Gross profit = 0.00299 X 10,000 = $29.90
Note that the net profit will be realized when the trading costs are subtracted. Richard traded with over $11,000 only to make a profit of $29.90 less the trading fees. This should be quite discouraging; investing so much and gaining so little.
Example 2: Assuming Richard sets a target of 40 pips for himself and needs a gross profit of $2,000. How much capital will he need to open the same position at the same price?
He will need to trade higher volume, which means more lots.
Gross profit = pips gained X lots
$2,000 = 0.00400 X lots
Lots = 2000/0.004 = 500,000 = 5 lots.
To open a position of 5 lots at the same price, he needs:
500,000 X 1.10289 = $551,445.00
The investment is massive and beyond Richard’s capital, but this is where leverage comes in.
Leverage is a tool that enables traders to open large volumes of trades higher than their invested capital. It multiplies the trader’s exposure in proportion to his trading capital. Leverage is expressed as a ratio and every forex broker allows its clients to trade on leverage.
In the examples above, Richard was trading and estimating with a leverage of 1:1 or no leverage at all. But, with a leverage of 1:10, it means that he can open positions that are 10 times more than his capital. So, with a capital of $100,000 and a leverage of 1:10, he can open trade positions that sum up to $1 million. So, leverage drastically reduces the capital required in forex trading.
The leverage available is decided by forex brokers for each asset or asset class. Some brokers offer a maximum leverage of 1:200 while others offer up to 1:1000. Regulated European brokers offer retail forex traders a maximum leverage of 1:30 on major currency pairs. This is in compliance to the leverage restrictions stipulated by the European Securities and Markets Authority (ESMA). Retail forex brokers in the United States are also limited to a leverage of 1:50 as imposed by the Commodity Futures Trading Commission (CFTC).
The concept of margin is very important in forex trading and also similar to leverage. Margin is the deposit required to open a position that is more than the forex trader’s account balance. Margin is expressed in percentage. It is related to leverage as follows:
- A margin of 1% is equal to a leverage of 1:100
- 2% margin is a leverage of 1:50
- 5% margin is a leverage of 1:20
Example 3: A trader has an account balance of $10,000. He wishes to open a short position on 4 lots of AUDUSD at a bid price of 0.74305. What is the margin required if the broker offers him a leverage of 1:50?
Notional value is the total value required to open the trade position with leverage. So,
Notional value = opening price X contract size
= 0.74305 X 4 X 100,000
Notional value = $297,220.00
Margin required = (1/50) X 297220
A leverage of 1:50 means that the trader gets 50 times more exposure than his capital. For every $1 margin put forward, he can open a trade worth $50. This represents a margin of 2% meaning that you need to make a down payment of 2% of the full position you wish to open. In example 3 above, the trader deposited a margin of $5,944.40; but was able to trade as if he had $297,220.
Free and used margin
When there are open positions in a trader’s account, the used and free margin is displayed on the trading platform. Used margin is the total amount of money required to maintain an open position while free or usable margin is the part of the trader’s capital that is not tied to any open trade.
Example 4: A trader has an account balance of $3,000 and opens trade positions as follows:
- buy position for EURUSD at an ask price of 1.10138
- buy position for GBPUSD at an ask price of 1.32509
- sell position for NZDUSD at a bid price of 0.69485
If he opens one lot of each currency pair at leverage of 1:200, calculate the used and free margin?
Margin required to open EURUSD position = 1.10138 X 100,000 X (1/200) = $550.69
Margin required to open GBPUSD position = 1.32509 X 100,000 X (1/200) = $662.55
Margin required to open NZDUSD position = 0.69485 X 100,000 X (1/200) = $347.43
Used margin = Total margin required for all open positions.
Used margin = $550.69 + $662.55 + $347.43
Free margin = Equity – Used margin
Free margin = $3,000 - $1,560.67
So, the trader has a free margin of about $1,439.33 which can be used to open more positions. But, $1,560.67 is the used margin which is locked by the broker as long as the trades are in progress.
This is a measure of the trader’s deposit to the used margin when expressed as a percentage. It is given as follows:
Margin level = (Equity/Used margin) X 100
Once a trader funds his account without opening any trade, the total equity is equal to his account balance. But, when the whole account balance is used to open positions, then the margin level is 100%. Many forex brokers place a threshold on 100% margin level as the least value allowed. Otherwise, at all times the margin level is supposed to be above 100%.
In example 4 above, with the 3 trades open, the used margin is $1,560.67 while the initial account equity is $3,000. So, at that time, we can calculate the margin level as follows:
Margin level = (3,000/1,560.67) X 100
Margin call is a call to action from broker to trader; to either close losing positions or add more funds to your trading account. Depending on the broker and settings, Margin call may be issued in form of app notification, sms, email or phone call. All brokers have a threshold for their margin call level for every trader account. Most brokers set their margin call level at 100%.
Most traders try to avoid a margin call because of its psychological effects. Receiving a margin call means that you are losing money and so, you have to close losing positions or add more funds to increase your free margin.
Stop out level
A trader may receive a margin call and ignore it hoping that the losing position will reverse. If unfortunately, the losses continue and the margin level drops to a certain threshold known as ‘stop out level’, the broker’s platform will initiate an automatic liquidation process of closing out the open positions one after the other. This action will increase the margin level until it reaches an acceptable limit or it may close out all open positions.
Some brokers set their stop out level at 50% of the margin level. So, once the margin level drops to the stop out level, automatic liquidation is triggered.
Advantages of Leverage and margin
A major advantage of leverage is that it reduces the trader’s capital. It is because of leverage that traders can commence forex trading with $100 or even less. Each broker fixes the minimum deposit allowed by traders to open an account. Brokers that offer high leverage allow smaller trading capitals.
High profit potential
When leverage multiplies your capital, it simply means that you can open more trade positions and make more profits. This creates the hope that a trader can start trading with a small amount of money and grow it into millions of dollars through high leverage. Most times, it is only a dream because leverage also comes with a cost.
The major disadvantage associated with leverage and margin is increased risk. Leverage has the potential to magnify profits and losses equally. This is why it is of often referred to as ‘a double edged sword’.
Example 5: A trader has $2,000 in his account which comes with a leverage of 1:300. He opens a buying position on 1 lot of EURUSD at 1.10162.
- Assuming he closed the trade at 1.10662 with a gain of 50 pips, calculate his net profits?
- Assuming he closed at 1.09662 with a loss of 50 pips, calculate the amount he lost?
- Profits = 50 X 0.0001 X 100,000 = $500
- Loss = 50 X 0.0001 X 100,000 = $500
From the trades in example 5, it can be seen that leverage is great when you are on a winning trade but a nightmare when on a losing trade. Note, that trading costs were not added to the calculation.
Leverage is used in forex trading to multiply your market exposure by allowing you to open trades that are worth multiples of your deposited capital. Margin is the part of your capital locked by the broker during a trade while allowing you to open larger positions. The percentage measure of your deposit to the used margin is known as Margin level. At any time, your margin level must be above 100% or you might receive a margin call from your broker.
Leverage and margin are exciting and powerful when the markets are moving in your predicted direction. But, if the trade reverses, losses are multiplied in the same proportion with profits.