The ChoosaBroker Trading Academy
5.5. Leverage and Margin Trading
One of the primary reasons why so many wannabe traders are drawn to the Forex market is the much higher leverage on offer in comparison to other popular assets like stocks and futures. While many of you may have heard of the term “leverage,” very few understand how it works and how it has a direct impact on your bottom line. In this lesson, we will learn:
Foreign Exchange Leverage Explained
When visiting forum or sites dedicated to Forex trading, you will likely see a lot of flashy banners broadcasting something like 50:1, 100:1 or even 500:1 leverage. What do these figures imply? Let us try to understand.
In the context of financial market trading, “leverage” can be defined as the capability to control a large amount of money by employing very little of your own and borrowing the rest from your broker.
Let us assume that a trader with US$1,000 in his account wants to trade big and his broker is willing to supply a leverage of 100:1. If the trader were to buy 1 regular lot of USDCAD without leverage, he would be required to put up the full value of the position, i.e. $100,000. But with the 100:1 leverage available, a mere $1,000 of the trader’s funds would be sufficient to open and maintain the $100,000 position.
Let’s say the $100,000 investment in USDCAD appreciates to $102,000. If the trader himself had to come up with the entire capital of $100,000, his return would be a paltry 2%. But fortunately with the 100:1 leverage, the trader was able to earn $2,000 by investing only $1,000, which translates to a whopping 200% return!
The foreign exchange leverage ratio of 100:1 in the above trade is significantly larger than the 2:1 leverage generally offered by equity brokers and the 15:1 leverage provided in the futures market. The 100:1 leverage may at first seem extremely risky. But currency prices, unlike stocks and futures, seldom change more than 1% on any given trading session. If currencies fluctuated as much as stocks, Forex brokers would not have provided so much leverage.
Foreign Exchange Margin Explained
When it comes to Forex trading, the term “margin” is often thought of as the fee that a broker charges the trader. That is incorrect.
In simple words, margin is defined the amount of money that your broker needs as a “good faith deposit” to allow you to initiate a buy or sell position. What your broker does is basically take your margin deposit and pool it with other traders’ margin deposits. This one “super margin deposit” is then used by the broker to place trades within the foreign exchange interbank network.
Margin is typically expressed as a percentage of the total value of a position. For example, to trade $100,000 currency units with a margin of 2%, an investor will have to deposit $2,000 in to his or her trading account, while a 1% margin will require an initial deposit of $1,000.
What is Margin Level in Foreign Exchange?
In order to better understand Forex trading, one should try to learn as much as they can about margins. One such key term is “Margin Level.” Expressed as a percentage, the Forex margin level is a risk management tool that will help you understand the influence of the currently opened positions on your trading account.
Different brokers may specify different limits for the margin level. A majority of them set it at 100%. This 100% limit is called the margin call level. Technically, when your account margin level falls to 100%, it means that all of your available funds are in use, and you will be restricted from taking any fresh positions.
How to Calculate Forex Margin Level?
For the serious trader, the margin level is a critical metric to keep an eye on. The formula to calculate it is provided below:
Margin Level = (Equity / Used Margin) x 100
Where, “Equity” is your total account balance plus the floating loss/profit of your open positions, while “Used Margin” is the amount of money that your broker sets aside from your account balance to keep your trade positions open.
For example, if your trading equity stands at $5,400 and your used margin is $500, the margin level would be 1,080%. Thankfully, most trading platforms automatically do the calculations for us. In MetaTrader 4, the margin level is available in the “Terminal” window under the “Trade” tab.
From the point of view of the trader, the margin level is an important indicator of the volatility within his or her trading portfolio. Generally speaking, you will want to maintain a margin level of 500% or higher. Levels below 500% signify that you are likely undertaking too much risk.
Final Few Notes
It can be hard to determine the ideal leverage level when trading Forex. As a rule of thumb, the longer you expect to stay in a trade, the lesser the leverage you should avail. This is because the longer you keep a positions open, the greater will be the market fluctuation, exposing you to the unwelcome scenario of a big loss. In contrast, when a trader initiates a position that is expected to last for a few minutes, he will be looking to extract the maximum amount of profit within the limited time frame. Usually such a trader will employ high, if not the highest possible leverage.