10 FOREX Leverage and Margin
What is FOREX Leverage and Margin Mean? And how can I profit from it?
“Leverage” and “margin” refer to the same concept, just from a slightly different angle.
When a trader opens a position, they are required to put aside a fraction of that position’s value “in good faith”. In this case, the trader is said to be “leveraged”. The amount that is required to be put aside is known as the “Margin Requirement”.
In short, you can use margin to create leverage.
While many traders know of the words “leverage“ and “margin” very few actually understand what they are, how they work and how it can directly impact their ROI.
To understand better how all this works it is important to first understand the different figures you see displayed in your brokerage account.
- Balance: This is the cash sitting in your brokerage account from deposits, withdrawals and closed trades, it does not include any P&L from any open positions!
- Equity: This is the sum of the Balance and includes any open positions current P&L (this is your real account value)
- Margin: For every position you have open, your broker will put aside a certain amount of money as margin, this is the sum of margin from all open positions.
- Free Margin: This is the Equity – Margin. If this goes to $0.00 you will get a margin call!
- Margin Level: This is the Equity / Margin displayed as a percentage.
Here is an example out of a MT4 trading account that has 500:1 leverage (0.2% margin) Leverage is displayed as a ratio and margin is displayed as a percentage.
- Balance: Closed out P&L | $49,774.39
- Equity: Balance + Open P&L | ($49,774.39 + -$7.53 = $49,766.86)
- Margin: 0.2% (500:1 leverage) of the open position price | ($119,291.00 * 0.2% = $238.58)
- Free Margin: Equity – Margin | ($49,766.86 – $238.58 = $49,528.28)
- Margin Level: Equity / Margin | ($49,766.86 / $238.58 = 208.5944 or 20,859%)
Let’s say you bought 1 standard lot of the EUR/USD pair at 1.0515 and then later sold it at 1.0715. You would have made a 200 pip profit – Sweet!
The 200 pip profit would be = $2,000.00 USD.
ROI = (Return on Investment) = 1.9% – Not too bad.
If you used 400 times leverage (400:1) or 0.25% margin You would only had to have $262.88 USD in your bank account.
The 200 pip profit would still be = $2,000.00 USD
ROI = (Return on Investment) = 760.8% – WOW!
That is a massive difference in ROI’s and the trader did nothing different in the actual trade, they just used margin to leverage their results.
Let’s now look at the same example, but instead of making a 200 Pip profit, we made a 200 pip loss.
The 200 pip loss would be = $2,000.00 USD
Trade loss as a percent = -1.9% – Not too bad.
If you used 400 times leverage (400:1) or 0.25% margin. You would only had to have $262.88 USD in your bank account.
The 200 pip loss would still be = $2,000.00 USD
Trade loss as a percent = -760.8% –
WOW again… but not for the good reasons : (
Obviously your loss should not be more than what you have in your account, so really once it got close to 100% loss your broker would give you a margin call and if you did not deposit more margin (funds), they would close out the position for you. Stopping you from losing more than what you had in your account.
And in this case you have only lost $262.88 dollars (what you had in your account), but if you used the same 400:1 leverage on the $100k account, the same thing would still have happened, account gone… : (
If you used 400:1 leverage or 0.25% margin
And used the same $105,150.00 USD – you could have traded 400 lots.
The 200 pip loss would be = ($2,000.00 * 400) = $800,000.00 USD
Trade loss as a percent = 760.81% – $105,150.00 GONE – Ouch, Ouch, Ouch!!!
So you need to be careful when trading with leverage, yes it can help, but it can also really hurt!
Margin really has 2 main purposes.
- 1 Gives your broker a down payment / deposit on the money you are effectively borrowing.
- 2 And even more importantly gives the broker some “wiggle room” in case the chocolate stuff hits the fan.
If you have a trade go against you and you do nothing, your broker will close out the trade for you. But if the market is moving fast, the broker might not be able to close it out fast enough and your account will have a negative balance. How many traders do you think will pay back their brokers by depositing more money to cover their losses?
Not many! And the ones that do, generally do so only after a lot of chasing up by their broker, at the brokers expense.
So what’s a Margin call?
This is simply your broker letting you know that your trade / trades are going against you.
Your available free margin is running very low and you’re getting close to being closed out by your broker to stop your account balance becoming negative.
This normally happens when your account gets close to running out of money, about when your equity is at, or below 20% of the required margin level.
Although this is called a “Margin Call”, your broker may not actually call you, they may just send you an email, or text letting you know that you need to look at taking 1 of the 3 following actions:
- 1 Making the market go in your favor
- 2 Closing out your position
- 3 Adding more funds to your account
It is VERY IMPORTANT that you keep an eye on your Equity, it is not your brokers, or anyone else’s job to manage your money, it is YOURS!
And remember that depending on global market events, your broker can change the margin level to ensure that in volatile markets their “wiggle room” is big enough.
Again you need to keep up with this information and not trade using all your available leverage, give yourself some wiggle room.
FOREX Leverage and Margin Summary
One of the big reasons why so many people are attracted to the forex markets compared to other financial instruments is that forex usually offers significantly higher leverage than you would get with other tradeable financial assets, like stocks for example.
But this is probably also why many people fail at trading FX…
This why do people say Leverage is a double-edged sword
If you are not smart about how you use it, it can have a very destructive affect on your account.
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