Margin and leverage

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Margin and leverageMargin and Leverage

Margin and leverage are fundamental concepts that every beginning forex trader must understand to be effective.

What is leverage?

When you decided to buy a house for the first time, chances are you didn’t have enough money to buy the house at its listed price. Traditionally, you would put a down payment on a house of 25%, and borrow the rest of the money from the bank. Whether you knew it or not, but you were using leverage to buy your house.

Leverage gives you access to large sums of money with only a small initial deposit.

Leverages are shown as a ratio. For example, a 25:1 leverage will give you access to 25 times more money than you put in. In this example $4000 dollars will allow you to buy a standard lot, which is $100,000 worth of currency.

Different brokers will have different leverages. Typical leverages are 10:1, 20:1, 30:1, 40:1, 50:1, 75:1, and 100:1. If you are trading using 100:1 leverage, you would be able to buy a $100,000 of currency for only $1000. You are spending less of your own money to buy that currency. Why wouldn’t you use the highest leverage available?

The simple fact is that the higher leverage you use, the higher risk there is. The make more money when you are right, but you lose more money when you are wrong. Don’t forget:

High leverage = High risk.

Example of Leverage

Say you are bullish on the USD/CAD pair, and believe that the USD will become stronger compared to the CAD currency. In other words, you think the price will go up. At a price of 1.0662, you buy a standard lot using 25:1 leverage, which means spent $4000 to buy $100,000 of USD currency.

It turns out that you were right, and you sold the currency pair at 1.0702, which was 40 pips above what you bought it. You have profited approximately $400 USD from this trade from an initial investment of $4000 dollars. This means your return on investment (ROI) is 10% ($400 / $4000) from this trade. Not bad for one day’s work.

But imagine what would have happened if you bought it using 100:1 leverage. You will only spend $1000 to buy $100,000 USD. The price still increased 40 pips, which equates to approximately $400 USD. You ROI is now 40% ($400 / $1000).

From this example you made four times as much with a higher leverage. But if the price decreased 40 pips, the results would be the exact opposite. Using a 25:1 leverage, you would have only lost 10% of your initial investment. But if you used 100:1 leverage, you would have lost 40% of the investment, which is almost half of what you put in!

The amount of leverage you use will be determined by how well you handle risk. Some people are naturally more capable of handling risk than others. But when you first start out, I highly recommend not using more than 25:1 margin.

What is Margin?

The margin is the amount of money as a percentage that you would have to put up to buy a contract. Depending on your broker’s margin policy, if your account balance dips below the margin, you will get a margin call and all your open positions will be closed for you.

How to Calculate Margin?

Leverage and margin are related by the following formula:

Leverage = 100 / Margin

Margin = 100 / Leverage

So 25:1 leverage would indicate 4 percent margin (100/25). Here are some other common ones:

100:1 Leverage = 1% Margin

50:1 Leverage = 2% Margin

40:1 Leverage = 2.5 % Margin

30:1 Leverage = 3.33 % Margin

25:1 Leverage = 4% Margin

20:1 Leverage = 5% Margin

10:1 Leverage = 10% Margin

I think you get the idea.

In this next example, I am buying a mini-lot ($10,000). The margin used is calculated automatically for me on the picture below. In this example, we want to find out how the margin is calculated if our leverage is 50:1.

You are putting up $200 USD of your own money to buy a $10,000 mini contract. Therefore you are putting up 2% (200 / 10,000) of your own money. To calculate the margin, we take 2% of $10,000, which is $200.

How to Calculate Margin 2

What happens when the base currency is not the same as the home currency? Every currency pair is listed with two numbers. For example, you will often see EUR / USD = 1.40917 / 1.40912. The first number is the base currency, and the second number is the quotes currency. The home currency is USD if your forex account was deposited using US currency. If this doesn’t make sense, click here to review the basics.

In this case, when you buy or sell a standard lot, the currency of that lot will be in Euros, but the margin will still be listed in your home currency (USD in our example). How does the margin get calculated? Let’s take a look at another example.

We are buying a standard lot of the EUR/USD pair. Once again, the margin is automatically calculated for us. But how did we arrive at that number?

Let’s take a deeper look. Since the quoted price is 1.40792, this means that it costs 1.40792 USD to buy 1 EUR. A standard lot of 100,000 EUR will cost 140,792 USD. I am glad that we have margin because I sure don’t have that kind of money!

We know from our broker what the leverage is (50:1 in this case), so we can calculate the margin. A 50:1 leverage is the same as 2% margin. Two percent of $140,792 is $2815.84, which is the margin listed. We now know how to calculate the margin. The margin calculation uses the following formula:

Margin Used = ((Base Currency / Home Currency) * Units) / Margin Ratio

Base Currency / Home Currency = EUR/USD = 1.40792

Units = 100,000

Margin Ratio = 50

Margin Used = (1.40792 * 100,000) / 50 = $2815.84

How to Calculate Margin 3

We will go one step further determine how the margin is calculated if both the base currency and quote currency are different than the home currency.

The home currency is still USD, but now we want to buy 100,000 units of the EUR / GBP pair.

We will use the formula from above to calculate the margin.

Base Currency = EUR

Home Currency = USD

Base / Home Currency = EUR / USD = 1.40884

Units = 100,000

Leverage = 20:1

Margin Used = (1.40884 * 100,000) / 20 = $2,817.68 USD.

The best person to tell you what type of leverage to use is you. Only you will know what type of risk tolerance you have. However, I highly recommend not using too much leverage if you are just learning how to trade. Most professionals don’t use more than 50:1 margin, and neither should you.

You should also know how to calculate the margin so you can plan ahead and know how much of your money is actually being risked, and avoid the nasty margin call.