In this Wiki, we will examine what Margin and Leverage are, the differences, and the affect these will have on risk.
Margin and Leverage
Currency is traded in lot sizes ranging from 100 to 100,000 unit lots on the retail spot market. A unit of currency could be in several currencies such as a dollar, euro, pound, or whatever the traders account denomination may be. By trading multiple lots, a currency trader can hold a position of virtually any size, provided that the trader has the capital to match it unit for unit.
Investing in a single 100,000 lot is not practical for most retail traders, and even if you could, why would you? It would be an extremely inefficient use of capital to tie up 100,000 units in one standard currency lot.
Currency is typically traded through a margin account, which allows the trader to control a position much larger than the capital he has in his account. Margin and leverage are important tools that are, unfortunately, misunderstood by many traders. In this section we discuss what margin is, how leverage works, and how leverage affects risk.
Margin is represented by the percentage of capital required to maintain an open currency position with your currency dealer or broker. The margin amount represents a security deposit to the dealer and says that you are creditworthy for the full amount of the position you are trading.
Many traders believe margin is actually part of the currency you are trading, but it is not. Your currency dealer loans you the full position size in return for your security deposit, represented by the margin amount. The percentage is usually fixed across many currency pairs, although some illiquid or exotic currencies may have higher margin requirements, but that is determined by the individual broker. If your currency dealer requires a 1 percent margin and you open a 100,000-unit trade, your margin requirement to keep this position open is 1,000 units of currency in your account.
If your account balance falls below the required margin amount, your currency dealer will usually liquidate the largest position first or sometimes all open positions to avoid further losses. This process is known as a margin call. Although margin calls are painful, they actually protect you from owing the dealer money on a position that has gone bad. Without automatic margin calls, your account could fall into a negative balance and you would owe the dealer money to cover the losses.
Maintaining an account balance large enough to manage normal market losses without approaching your margin requirements is a crucial step in money management. Most currency trading platforms will calculate your usable margin and used margin in real time to ensure that you always know where your account stands in relation to the margin requirements on open trades.
What Is Leverage?
Leverage is simply a function of the margin you are required to maintain for each trade. Leverage is measured in a ratio format such as 100:1 or 25:1. For example, if your margin requirement is 1 percent on a $10,000 trade, you must maintain at least $100 in your account to keep that position open. This represents 100:1 leverage because you control $100 for every $1 in your trading account.
Some dealers advertise that they allow leverage as high as 2,000:1. However, using that amount of leverage on every trade might not be suitable for all traders as it could get them in trouble if they have poor money management or not enough experience to know how to control that amount of leverage.
The table below illustrates how leverage and margin work together. Assuming that a trader buys one standard currency lot worth $100,000, the leverage amount varies depending on the trader’s margin requirement. As margin requirements are increased, leverage is decreased.
The Relationship between Leverage and Margin Requirements:
An image of the relationship between leverage and margin requirements.
The Effect of a 1% Margin on Available Account Balances:
An image of the effect of a 1% margin on available account balances.
The Effects of Margin and Leverage on Risk
Margin and leverage can affect risk in different ways. Margin requirements climb as the trader accumulates open positions, which could leave your account at risk for a margin call, even when the individual positions are small or profitable. This is a death-by-1,000-cuts scenario because the trader has over leveraged his account with small trades to the point that there is no room between margin requirements and the account balance. In this scenario, what typically will happen is the broker will close the largest or most negative trades first in order to free up margin and give the trader some leeway to get the account back in order. If the account continues to dwindle then the broker will close out the remaining positions to keep the trader from getting into a negative account balance situation.
The previous table illustrates how fast a trader with a small account balance can get himself into trouble by opening too many positions. The trader with $500 who opened four $10,000 positions left himself with only $100 to absorb any potential market losses that occur during the life of that trade. The trader must understand how much margin will be consumed by a trade before he opens it or he could find himself without sufficient usable capital to maintain the trade before a margin call occurs.
One way for the trader to keep his account in check is to trade without the use of any leverage. This does not mean that traders should not have access to an account with high leverage. What it means is that is that if a trader has an account balance of $10,000 then trading 1:1 leverage would mean to only take a position of $10,000. Your margin requirements may only be $100 to support this $10,000 position but if the market went against the trader then it would take roughly a 10,000 pip move to wipe out the account. That is a massive move and not likely to happen unless the trader holds on to a losing trade for way too long. Making 50 pips on a trade would mean an account appreciation of roughly 0.5%. All you need is to have a few decent move trades per month to make 5-10% per month.
Understanding how margin and leverage will affect your positions is crucial to surviving as a currency trader. Opening too many trades or using too much leverage with large trade sizes is a potential recipe to wipe out a trading account before winning trades can grow it.
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