Margin (Leverage)

Ok, if you are feeling tired by now, too much material, etc. take a rest; you are going to need it in this lesson.

Margin Trading

In contrast to other financial markets where you require the full deposit of the amount traded, in the Forex market you only require a margin deposit. The rest of the amount will be granted by your broker (you will borrow it from your broker).

The leverage could go as high as 400:1 depending on your risk profile and the broker chosen. 400:1 means that you will only need 1/400 in balance to open one position (plus the floating losses). Under this scheme, you only need .25% of the total amount traded.

For example, if you were to trade one standard lot using 400:1 (which equals 100,000 units of the base currency) you would only need $250 ($100,000/400 = $250) for indirect currency pairs [USD quoted as the base currency].

But be careful, HIGH LEVERAGE CAN LEAD TO SUBSTANTIAL LOSSES AS WELL AS SUBSTANTIAL PROFITS. We will get in to detail later on.

Leverage Comparison

[Table 3]

There are two things to be considered about margin trading:

1 – Margin trading allows us to keep our risk capital at the minimum since a small amount of money is used to conduct a bigger transaction.

2 – The greater the leverage used, the more risk capital you have at risk, and this takes us to the next concept…

Margin Call

A margin call is the traders’ worst enemy. Unfortunately, this happens to too many traders, some because the use of poor money management techniques (or no usage at all) and some others because they are not even aware of it.

A margin call arises when the balance of the account falls below the maintenance margin (capital required to open one position, for example $250 when using 400:1 or $1,000 when using 100:1 on one standard lot). See the above table.

In a margin call your broker sells off (or buys back in the case of short positions) all your trades.

How so? Let’s dig in a little deeper and try to calculate the maintenance margin…

How to calculate the maintenance margin

Again, most brokers calculate this value automatically but it is good to know how this number is calculated.

A trader goes long EUR/USD at 1.2318 on one standard lot. He is using 100:1 or 1% of margin.

He bought 100,000 Euros at 123,180 USD, so the maintenance margin in USD is 1231.80 USD (123,180 x 1%).

If this trader had used 200:1 or 0.5%, the margin would be at 615.9 USD (123,180 x 0.5%)

For direct currencies (or currency pairs where the USD is the base currency) this calculation is simpler:

Since the transaction is in USD, we only need to obtain its percentage in the following way:

If we go long USD/CHF on one standard lot at 1.1445, we are using 100:1

We bought 100,000 USD and paid 114,450 CHF for them, so the maintenance margin in USD is US$1,000 (100,000 x 1%).

Let’s take a concrete example on a margin call:

One trader has opened an account to trade the Forex market. She has made an initial deposit of US$4,000 to her trading account. The next morning she decides to go long EUR (EUR/USD) at 1.2318 on two standard lots (the position equals to US$246,360 = 2 x US$123,180).

She is using 100:1, so the maintenance margin would be US$2,463.6 (US$246,360/100=US$2,463.6).

The next morning, as she wakes up and opens up the charts, dang!!! The EUR has fallen like a rock. When she opens her trading platform, the balance is at US$2,463.60. The adverse price action got her margin called.

When she entered the trade with two standard lots, the maintenance margin raised at US$2,463.60; she only had left the other $1,536 to support her losses. A 100 pip movement on the EUR in two standard lots accounts for US$2,000. That night, the EUR fell 113 pips, and all positions were closed by the broker.

This illustrates the perils as well as the advantages of high leverage!