Forex leverage and margin explained
Forex thrives above other financial markets for so many reasons, one of which is the subject of discussion in this article— The concept of leverage and margin.
Forex leverage is a loan that is provided by a broker to an investor that enables him to trade a larger amount than his/her initial balance. The ratio can be 2:1, 3:1, 10:1, 20:1, 50:1, 100:1, and 200:1 up to 500:1. For example, if you deposit a $10,000 in your account, and you choose to trade with a leverage ratio of 100:1, you can trade up to 100 times $10,000, which equals to $1,000,000. In other words, the leverage provides the means to an investor to have increased trading capital giving him/her the opportunity of having a maximized outcome.
Margin is the value of open positions multiplied by the margin percentage. The margin links directly to the leverage level of the account.
When the margin level of an investor reaches 100%, the investor no longer has any free margin to open a new position. A margin call is when the margin level drops to 50%; at this point, the investor needs to deposit more money or start closing some of the open positions to meet the margin requirement. However, if the positions keep losing, and the margin levels drop to 20%, the account will be stopped out automatically by the broker. The positions will be closed to return the margin level to 100% by so doing, both the broker and the investor will be protected and prevented from losing more money than initially deposited.
Higher trading leverage would give you more buying power, so you can potentially enter larger positions and have more considerable exposure (larger trades). With larger transactions, even a small market movement can result in a significant profit or loss. With higher leverage, your margin requirement decreases.
What leverage should I use for forex?
There is no clear-cut leverage that forex traders should use; it is mainly a function of the trader’s strategy and the foresight of the market move.
A good rule of thumb is to make sure that you could make at least five trades at any given time, and that those trades could all go up to 250 pips negative at the same time before you would run out of useable margin and thus incur a margin call. This formula is the absolute maximum that you should trade in your account, and you should have a plan to keep any trade from ever reaching its maximum negative of 250 pips.
If you should go by the above rule of thumb, to figure out what trade size and leverage to take, you should divide your account balance by 5. This step will give you the maximum amount you should allocate to any one trade. Using the example of a $5,000 account balance, the maximum allotted to any one trade would be $1,000. But note that this $1,000 represents the margin requirement and the 250 pips cushion for the potential negative equity in the trade.
You will discover that if you are trading with a leverage ratio of:
- 50:1 – you should not make your trades larger than two mini lots each.
- 200:1 – you should not make your trades larger than three mini lots each.
- 500:1 – you should not make your trades larger than four mini lots each.
Staying with these parameters on trade size, it will have a very great impact on your trading account overall. The amount of money that you will make on each winning lot will probably be less, but chances of closing trades for a loss significantly reduces, and overall, the impact on your account will be positive.
Just as important as knowing how considerable and what leverage to make your trades, it is also essential to have a coherent trading strategy. Your strategy should have a history of producing more winning trades than losing trades, and you should also have a plan to mitigate negative equity in trades that do go underwater.
Leverage stocks trading
Leverage in the stock market is also referred to as margin trading, which is borrowing capital to invest in more stock than you can afford on your own. Buying stocks on margin with leverage can potentially increase the investment profits. Margin trading has accompanying interest charges, and the charges are debited from your account. It is used for short-term trading because the longer you hold the position, the higher the cost; this has an overall reduction effect on your account.
Margin trading involves higher risk, and it is primarily regulated by the Federal Reserve Board, the New York stock exchange, and the Financial industry regulatory Authority.
How to calculate leverage
Forex leverage is the percentage of funds that you are allowed to borrow from your broker and is usually stated in ratio. The margin requirement is the amount of money that the broker will require you to put up to initiate a trade.
To calculate the margin requirement, you need to know three things:
- With what leverage you are trading?
- What the actual price is for the pair you are trading at the moment you take the trade.
- What size trade you are going to make.
Exposure/Leverage = margin requirement.
- Account: $1,000 AUD
- Trade 0.01(micro lot) of AUD/USD;
- 1 micro lot = 1000 AUD (exposure);
- So, to know how much margin you need;
- If you use a leverage of 1:1, 1000 (exposure)/1 (leverage) = $1,000 (margin);
- But if you increase your market leverage ratio to 400:1;
- Exposure: $1000 AUD (1 micro lot);
- Leverage: 400:1;
- 1000 (exposure)/400 (leverage) = $2.5 (margin).
Leverage and the associated margin requirement are essential to your trading because it directly impacts the number of and size of trades you can make safely at any one time.
As a forex trader, you should note that leverage affects your buying power. Leverage changes your margin requirement, not a pip value. By increasing your leverage, you are reducing your margin requirement. Consideration of risk involved should always be taken into account. Good luck.