What is the Margin on your account? What is the Leverage for your trades? How do you calculate the required Margin? What is the difference between Margin and Leverage? Why does it matter? Why should you care about it?
Leverage is a tool. Say you are a painter; you don’t have a ladder or an extension for your roller; how high you can paint? Not up to the ceiling. You can cover up to 8 feet, more than that you will fail short. Paining the ceiling will be out of question. What happens if you have a ladder and an extension for your paint roller? You will be OK; you can complete your paint job. Leverage is like a ladder or a paint roller extension. Similar to painting, in trading you need tools. Leverage is the tool that will give you the extra mile.
Leverage
Leverage is the ratio between the actual amount of cash you have in your account and the amount of money you can trade using that cash.
Leverage is a ratio. The first part of the ratio is the amount you have in your account. The second part is the amount you can trade. If your Forex broker gives you a leverage of 1:50, then with $1 principal, you can trade up to $50.
Let’s look at what this means to your trading account. Say your account balance is $1000.00, and you don't have leverage, then you do not have a sufficient balance in your account to place a trade for one lot of EURUSD. If you try to place a trade for one lot, you will get a Red Card message.
So what solves this problem? Reduce the position size or increase leverage
What is the position size you can trade EURUSD with a $1000 account balance?
Without Leverage
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EURUSD quote = 1.15201
Account Balance = $1000.00
Position Size without Leverage = 1000/1.15201 = 868
With Leverage
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Account Leverage = 1:50
Add Leverage = 868 * 50 = 43,402
Position Size with Leverage = 40,000
With an account balance of $1000, without leverage you can trade a position size of 868 for EURUSD. With a 1:50 Leverage, using the same account balance, you can place a trade a position size of 40,000 for EURUSD.
Leverage is the extra trading power you have over your account balance.
Leverage for Forex range from 1:10 to 1:50.
Leverage allows you to trade large positions than what you could ordinarily trade using your account balance.
With a 1:50 leverage, you can multiply your gains by 50 times.
Leverage exposes you to losses in the same order if the trade goes against you.
When you use leverage, you are borrowing money from your broker.
You need to meet the margin requirements when trading using leverage.
Leverage can be helpful for a winning trade. By the same token, the outcome can be disastrous on a losing trade.
Understand the leverage and use it with proper risk management.
Never trade with maximum leverage. If the broker is giving you a 1:50 leverage, then use only 1:10 for your trades.
Margin
Margin is the amount required by the broker in your account to use leverage.
If your broker gives you a 1:50 leverage, that means you should maintain a margin of 2% of the traded position in cash and equity in your account. Margin requirement has an inverse relationship with leverage. As your leverage drops, your margin requirement will increase. As your leverage improves, your margin requirements will reduce.
Leverage = 1:50
Margin = 1/Leverage
Margin = 1/50 =.01 = 2%What is the Margin Required to trade two lots of EURUSD?
EURUSD quote = 1.15201
Leverage = 1:50
Position Size = 2 Lots = 100,000 * 2 = 200,000
Margin = 2%
Required Margin = 200,000 *.02 * 1.15201 = $4,608
When you trade with margin, you are borrowing from your broker. Now let's see how much you are borrowing when you make the above trade. Say your account balance is $5000.
Trade Size = 200,000 * 1.15201 = $230,402
Required Margin =.02 * Trade Size
Required Margin =.02 * $230,402 = $4,608This is the amount you have contributed to the trade from your account balance. Let's see how much you have borrowed when you placed this trade.
Trade Size = $230,402
Your Contribution = $4,608
Borrowed Money = $230,402 - $4,608 = $225,794Margin Call
The broker triggers a margin call when the equity in your account falls below the required margin.
Continuing with the above example, your account balance was $5000. You have used $4,608 for buying two lots of EURUSD. How much cash or usable margin is there in your account?
Account balance before placing the trade = $5000
Margin used in the trade = $4,608
Cash balance = $5000 - $4,608 = $392Remember, you borrowed $225,794 when you placed the trade on margin. You need to pay back this amount to the broken when you close the position. This is not a problem if your trade is on the winning side. What happens if your trade is losing money. Your broker will check the trade position and the equity in your account to see if it can meet the required margin. The broker can demand that the equity in the account does not fall below 100% to 120% of the required margin.
What happens to the equity in your account if the position loses 250 PIPS?
Position Opened at = 1.15201
Position lost 250 PIPS = 1.12701
Position is valued at = 200,000 * 1.12701 = $225,402
Equity in your account = Cash balance + Trade Position
= $392 + $225,402 = $225,794This is exactly the amount you borrowed from your broker when you placed the trade. The current equity in the account barely meets 100% of the required margin. Adding spread and transaction costs, the account balance is below the required margin. Now the broker will invoke a margin call and close the position to take back the borrowed amount of $225,794.
The broker will continuously monitor the equity in your account to see if it meets the required margin. If the equity in your account falls below the required margin, or if the amount falls near the amount borrowed, then your broker will invoke a margin call to close out the open positions.
Do not over-leverage your account.
Have margin in your account to absorb losses.
Use practical risk management.
Never trade over 5% of your equity on a single trade.
Use stop losses to manage trades.
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