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Part 3 - Learn Forex Trading: Margin and Leverage

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Scorpion
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Scorpion  

In a forex trade conducted through a trading platform, you are only speculating on the currency exchange rate and not actually buying all that currencies. Therefore if you speculate the movement of currency rates accurately you make a profit, otherwise not. Margin trading and leverage originate from this belief that speculation in currency positions can be met without real money supply.

Before we learn about Margin trading and Leverage it’s important we try to understand what is meant by lots

Lots

Units of currencies are bracketed and traded in lots. Lots could be any of the following: “Standar" lots, "Mini" lots, "Micro" lots, and "flexible" lots (also called “fractiona" lots).

"Standard" lot: Consists of 100,000 units of the base currency in a currency pair.

"Mini" lot: Consists of 10,000 units of the base currency in a currency pair.

"Micro" lot: Consists of 1,000 units of the base currency in a currency pair.

"Flexible" lots (also called “fractiona" lots): In this case you could choose your lot size as for instance it could be 0.5 of a lot, 1.2 of a lot, or any other number of units that suits you. Flexible lot is unlike the set lot sizes you could have with Standard lots, Mini lots and Micro lots.

Example

If you traded 1 standard lot of the currency pair USD/JPY, you're trading $100, 000, if you traded a mini lot it is $10, 000, and if you traded a micro lot it is $1,000. In short, a lot simply indicates how much of currency you are trading in that lot. Remember it is the base currency we are referring to when we talk of lots.

The choice of different lot sizes allows you to fine tune your trading style. For example if the invested funds in your forex trading account is on the smaller side, having an account with a dealer who offers micro or fractional lot sizes helps keep your risks on the lower side.

Leverage and Margin

Leverage is the method by which you could control a significant amount of money in forex trading by borrowing a large portion of the capital required for trading(from your broker) and using very little of your own money.

For example, “a $100,000 position (standard lot) in forex trading can be controlled by using just $1000 of your own money.” The leverage in this case is 100:1 (which is the ratio of 100,000 to 1000). Remember leverage is always numerically expressed in terms of ratio

For arguments sake supposing the leverage in the above example was 1:1. What would be the situation then? It would mean that you would be putting up- front the whole value of the position i.e. $100,000 as deposit and your borrowing would be nil. The 1:1 leverage would then look confusing as you are not borrowing anything, but nevertheless that’s the way it is. Retail forex trading is never done that way putting in the whole value of the currency position. On the contrary leverage is always used

What is margin and how does it correlate to leverage?

To understand “margin” let’s refer to the earlier statement “a $100,000 position in forex trading can be controlled by using just $100 of your own money”. This statement obviously refers to a leverage of 100:1.But significantly margin refers to the $1000 deposit you had to invest in order to avail this leverage. In other words, margin is collateral that you have to give your forex broker to conduct your forex trade using leverage. Margin helps secure your trade with your bro

Earlier we learnt that leverage is expressed in ratios. What about margin? How is it expressed?

Margin is usually indicated as a percentage of the full amount of the position. It could be 1%, 2%, 3%, 5% or even 0.25% and 0.5%. Different brokers have different margin norms. Once you know your broker’s margin requirement you can figure out the maximum plausible leverage that can be availed in your trading account

Calculation that links leverage and margin

Say your broker has stipulated a margin of 5%. Theoretically it means for a $100 position you need $5. So for standard lot of $100,000 you would require (100,000 x 5) divided by 100 =$5000. This means for a $100,000 position the broker would expect you to put a margin of $5000 which translates to a leverage of 20:1 (100,000 divided by 5000). Similarly you can calculate the maximum possible leverage for different margin requirements as for example for 3%, 2% and so on.

As you can see from above calculations, although leverage and margin are interrelated, leverage does not equal margin. Here’s how different margin requirements could translate to maximum possible leverage

Margin Leverage
0.25% 400:1
0.5% 200:1
1% 100:1
2% 50:1
4% 25:1

The concept of Margin per se explained above should not be confused with other similar terminology that you could get to see in your trading platform( as for example account margin, used margin, usable margin etc).

To reckon with this possible confusion, let’s try to understand the different variants of this terminology

Margin required: Corresponds to what we talked of earlier and refers to the concept of margin as expressed in percentage. In simple terms it’s the amount of money you have to deposit with your broker to open a position

Account margin: This indicates the sum of money in your forex trading account with your broker.

Used margin: When you open a currency position, your broker will lock in a certain amount of money to keep your position alive. Although this money is technically yours, you cannot utilize it furthermore unless and until your broker returns it to your account margin either when you close the position or when margin call occurs.

Usable margin: This indicates the amount of money remaining in your account to open new positions. Call it clear balance if you like!

How leverage magnifies the profit and loss.

Let’s assume the $100,000 position with 1:1 leverage (which means you invested the entire cost of the position yourself and had no borrowings) has now risen in value to $102,000. This means you have made a $2000 profit and your rate of return would be a mere 2% ($2000 profit divided by $100,000 money you invested as deposit)

But supposing you had a leverage of 100:1 and the $100,000 had risen to $102,000? In that case you would have invested only $1000 of your own money and the remaining $99,000 would have come as a loan from your broker. But importantly your rate of return has increased manifold, and in this instance would be 200% (divide $2000 profit by $ 1000 initial deposit and multiply that figure by 100).

As you can see from the above examples, a 1:1 leverage got you a mere 2% rate of return while a 100:1 leverage got you a 200% return.

Leverage is often referred to as a double edged sword. What does this mean? In the examples we talked of earlier the investment had made a profit of $2000(i.e. $100,000 had risen to $ 102,000).What if it is the other way around?

For example say on a 1:1 leverage what if the value of the position had declined from $100,000 to $98,000. This means you lost $2000 which means a negative rate of return (-2%). If the same deal was made on a leverage of 100:1 it means even more negative rate of return (-200%). What this means is that, just as increased leverage contributes to greater profits when the trade goes your way, similarly if the trade were to go against you increased leverage will certainly result in greater losses. This is what is meant by leverage being a double edged sword.

Margin Call

Margin Call is a call from broker to trader (either phone call, email or alert in the trading platform) asking him/her to deposit more money in the trading account failing which some or all of his trades will be liquidated by the broker at the current market price.

Why and when will the broker make a Margin Call?

Generally a broker will liquidate any position that is losing more than 50% of the margin (this is called Minimum Margin) it uses. The reason why it happens is to preclude the possibility of your loosing more money than you had originally invested.

How a margin call occurs is best explained by this theoretical example.

Let’s assume you are trading in a Mini account with 1% margin and have deposited $10,000. You then buy 1 mini lot of EUR/USD. Your account info snapshot will look as follows

Account No. Balance Equity Used Margin Usable Margin
001 $10,000 $10,000 $100 $9,900

Supposing you had closed this position by selling it at the same price as it was purchased, then your account information snapshot would have reverted back to:

Account No. Balance Equity Used Margin Usable Margin
001 $10,000 $10,000 $0 $10,000

But you didn’t close the position. On the contrary you decided to keep going

Assume you decide to buy a further 60 lots of EUR/USD making it a total of 61 lots

Your account info snapshot will now look as follows.

Account No. Balance Equity Used Margin Usable Margin
001 $10,000 $10,000 $6,100 $3,900

From the above consolidated position you stand to make great profits if EUR/USD rises as you had expected. But it will be a terrible scenario if EUR/USD falls

Assume the EUR/USD starts to fall, in which case your Equity will fall too. Your Used Margin will remain at $6100. But once your equity equals the used margin or drops below $6100, you will have a Margin Call. This means that some or all of your 61 lot position will immediately be closed at the current market price, unless you take steps to increase your equity to bring it sufficiently above the used margin. This basically explains how a margin call could be triggered.

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