Forex Leverage and Margin Trading Guideline (PDF)
The concept of ” Forex leverage” is very significant in the foreign exchange markets. In fact, while he represents a priceless tool that can improve potential profits, the Forex leverage or margin level trading can also raise potential losses. That is why it’s essential to choose adequate Forex leverage to ensure long-term trading success. So, during this money management guide, we will try to introduce the benefits, as well as the drawbacks of this concept.
What is Forex leverage?
Leverage is one of the most important concepts that we should understand when trading Forex. Actually, Forex leverage represents an essential tool that allows Forex traders to control larger trading positions (in terms of size) with a smaller amount of actual trading funds. In fact, brokers provide Forex traders with multiple leverages. Every trader has the right to choose the leverage that suits his preference and his trading strategy. However, it is important to know that profit and losses are based on the full value of the trade and not just the deposit amount.
For instance, in the case of using a 50:1 leverage, means having 1$ in a trading account gives you the possibility to control a position worth 50$.
To illustrate further, let’s take a standard USD/JPY trade. So, to buy or sell a 20000 USD/JPY without leverage would require the trader to put up 20000$ in account funds, (the full value of the trade). Or, with a 50:1 Forex leverage, we only need a deposit of 2% of the amount. That means 400$ of the trader’s funds.
Nevertheless, some currency traders consider that using Forex leverage signifies trading with a borrowed capital and funds that are not yours. Thereby, using leverage can be risky.
What is margin in forex?Simply, we can define the margin as the minimum sum of money that needs a trader in his account, in order to open and keep a leveraged trading position. In simple terms, we can describe the margin as the funds set aside by the broker so that we can handle larger trades. For example, in order to open a position worth 10000$, with Forex leverage of 200:1, the broker will put aside or locked-up 50$ from our account (0.5%). Usually, brokers express the margin as a percentage of the full amount of the trade. Hence, we will see them demand 1%, 5%, or even much more. Regardless, the requirement margin varies from one broker to another. Consequently, talking about the margin will lead us to define some other related terms such as :
- The required margin (the used margin): is the necessary amount of money needed to keep the current trading positions open. This amount will be locked-up by the broker until the positions close.
- The available equity (available margin): represents the available funds in the account that is available to open further positions. (funds that are not used yet).
- Margin level: represents the available margin or the available funds depicted as a percentage.
- Margin call: It happens when the margin level of the account decreases or falls below a pre-determined value. As a result, we will face the risk of liquidating the current positions. So, in order to avoid the “margin call”, we should continuously manage and monitor our “margin level”.
Thus, knowing from the beginning what each broker requires as a margin will help you, not only in choosing the suitable one. But, also in calculating the maximum Forex leverage that you can wield.
As we mentioned earlier, most brokers express the Forex leverage as a percentage. So, a (100:1) leverage ratio means that the minimum margin requirement for the traders is 1/100 = 1%. Then a 10000$ would require 100$ as a margin.
How to calculate the margin level in Forex?
The margin level is something that no Forex trader can afford to ignore. Because, as we already mentioned, to guarantee that your trading account is sufficiently funded and to avoid a margin call, we need to monitor our “Forex Margin Level”. In fact, he represents the simple way for traders to keep following their trading account status.
Nevertheless, the formula for calculating the margin level in Forex is simple. We just divide the equity by the used margin, then we multiply the resulting figure by 100.
Forex margin level (%) = ( Equity / used margin) * 100
For example, let’s consider a trader that places $100 000 in a forex account and opens two Forex trades. These two trades require an $80 000 as a margin. Then, the equity = $100 000 ; the used margin = $80 000 ; the available margin = $20 000. Thus:
Forex margin level = (100 000 / 80 000) * 100 = 125%
The Forex margin level equals 125. It is above the 100% level. So, we can judge it as acceptable. However, the higher the margin level, the more fund is available to use in further trades. Hence, we consider a Forex margin level below the 100 as risky. Because at this level, below 100%, all the margin is in use. So, brokers generally prevent traders from opening new trades and may place them on a margin call.
As a result, it is essential that traders understand and learn Forex leverage as well as the margin close-out rule set by the broker in order to avoid the liquidation of current positions. So, when an account is placed on a margin call, the account will need to be funded immediately to avoid the liquidation of current positions. However, brokers impose this in order to bring the account equity back up to an acceptable level.
Trading With High Forex Leverage Example
Overall, we can’t assume that high leverage is good or bad in Forex trading as it represents a risky system. In effect, trading with high Forex leverage permits us to place larger orders as it leverages the buying power. Which can’t be done with a low deposit account. Moreover, high leverage is important in the Forex market, as it allows small price movements to be rewarded by larger profits (through magnifying the value of pips). So, the higher the Forex leverage, the bigger the potential returns.
For instance, let’s consider a trader with a 20 000$ account. However, he decides to use the 50:1 leverage. So, this means that he will be able to open trades for up to 1 000 000$. Supposing now that he opens a trade of 10 standard lots with the USD as the base currency. Hence, each single pip movement will cost (0.0001*100000)*10 = 100$.
Thus, in the case of losing 100 pips, the total loss will be 100*100$ = 10 000$ which represents 50% of the 20 000$ trading account. At this point, it will be very difficult for the trader to compensate for the loss and to manage his account. In the opposite direction, making a profit of 100 pips means 10 000$ earnings (50% of the trading account).
In conclusion, trading with high Forex leverage requires a good understanding of money management and margin calls in particular.
Trading With Low Forex Leverage Example
Actually, trading with low Forex leverage suits most the beginner as well as the conservative traders (risk-averse traders). regardless, this type of trader shun leverages like (100:1) or (200:1) and prefers much lower ones that might be more appropriate. (2:1), (3:1), (5:1), or even (10:1).
In fact, the maximum leverage is lowered by numerous respected authorities such as the US regulated Forex brokers or the European brokers “ESMA” who lowered Forex leverage respectively to (50:1) and (30:1) due to regulations and high risks.
For instance, let’s consider a trader with a 20 000$ account, who chooses to use a leverage of (5:1). Then, he will be able to control 100 000$ in currency. In the case of opening trade of 10 mini lots with the USD as the base currency, each one-pip movement will cost (0.0001*10000)*10 = 10$.
Thus, if the market moves against him and he procures a loss of 100 pips, then, the total loss will be 100*10$ = 1000$ which represents 5% of the 20 000$ trading account. However, losing 5% can’t impact hugely the trading account.
In brief, using Forex leverage permits us to quick yields, and expand capital by controlling a larger amount in the FX market with a small trading account. But, in order to manage its risks, we should develop an effective money management strategy to reduce losses and protect our trading accounts.