Trading Course for Beginners: Course 2

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Lesson 6 What is Margin and Leverage? (Beginners)

Lesson 6 What is Margin and Leverage? (Beginners)

Reading Time: 14 minutes

Margin and leverage—both closely related concepts—are frequently misinterpreted in the financial markets, particularly in the retail spot Forex market, sometimes referred to as the foreign exchange market.

Leverage is defined as a facility to increase exposure greater than a trading account’s available equity. Larger returns are possible when employing leverage, though the trader or investor must also account for an increased risk of bigger losses. Precisely for this reason, leverage is often expressed as a ‘double-edged sword’: gains and losses are evenly magnified.

Represented by way of a fixed ratio, leverage is established by your broker and remains unchanged unless the account holder modifies leverage settings through their broker’s client portal. The leverage ratio’s main purpose is to determine the amount of required margin. Each broker works with a maximum allowable leverage: 50:1, 100:1, and 500:1 are standard ratios in the industry. FP Markets offer leverage of up to 500:1 on the Pro Account, while a retail account features a leverage offering of 30:1. Those using MetaTrader trading platforms (either a live or demo account) can check the amount of leverage their account is set to by pressing Ctrl+N (Navigator) and hovering the cursor over account details.

Leverage

The meaning of leverage becomes puzzling for beginner retail investors when the concept of margin enters the equation—commonly termed as ‘margin trading’ or ‘trading on margin’. Your FX broker allows clients to leverage a position (one of the advantages of derivatives trading) by only putting up a small percentage of the total value of the position size: the initial margin. Think of margin as collateral to trade a larger position size.

Knowing that a percentage of the account is used as collateral, the idea of leverage begins to have meaning. By trading on margin, the account holder gains access to identical price fluctuations (gains/losses) as if trading the position unleveraged, yet without the total upfront cost. This is best demonstrated through two examples:

1. Unleveraged Transaction

An American citizen wishes to purchase 100,000 euros. For this, the EUR/USD exchange rate is used, which, in this example, trades at $1.20000. Note that this is a direct quotation (the foreign currency is the base currency). To purchase 100,000 euros, the ‘cost’ in US dollars is 120,000 USD. Two months later, EUR/USD trades at $1.22000: 200 pips higher. Let us assume the American citizen decided not to invest the 100,000 euros and wanted to convert euro back to dollars, a gain of 2,000 US dollars would be realised (100,000 * 1.22000) in light of the currency pair’s appreciation.

2. Margin Transaction

Instead of physically buying 100,000 euros and selling 120,000 USD, the same American citizen is now trading on margin. The key point here is that by using margin, traders and investors can trade the equivalent value of an unleveraged transaction with a considerably smaller amount of money. The same profit in example 1 is produced with a margin trade, as shown below.

Account features:

• Account balance: 10,000 USD

• 100:1 account leverage

• 1 per cent margin

• EUR/USD exchange rate: $1.20000

Using margin, a 1 standard lot position can be employed (100,000 units of the base currency). The margin in this case (term currency identical to account currency) is found through the following formula:

(Position Value * Exchange Rate) * Margin Percentage

1,200 USD Margin Requirement = (100,000 * 1.20000) * 0.01

In terms of pip movement, in this example, the account holder will be working with 10 USD per pip (the same pip value as the unleveraged position). The ‘effective leverage’ (notional position * account balance) is 10:1 and, as such, will experience a precise imitation of an unleveraged position, only without the upfront cost.

After the trade is executed, the account equity is 10,000 USD and free margin is 8,800 USD (used margin is 1,200 USD). Two months later, as in example 1, EUR/USD trades at $1.22000. Assume the American citizen decides to liquidate the margin position at the current price, and the same 2,000 USD gain is realised, minus commissions. Equity equals 12,000 USD and free margin increased to 10,800 USD.

Taking this a step further to demonstrate leverage, assume the account holder increases the position size by 300,000 units (3 standard lots) at the same exchange rate ($1.20000). The pip value is now 40 USD per pip, with used margin priced at 4,800 USD (400,000 * 1.20000 * 0.01) and free margin standing at 5,200 USD. The account’s price fluctuations will become extremely volatile by increasing the position size. If equity declines by 5,200 USD (100 per cent margin), the account holder faces a margin call and will have to deposit additional funds or risk hitting the brokerage’s stop-out level, which for FP Markets is set 50 per cent beneath the used margin.

As you can see, trouble can arise when a trader or investor uses too much margin. This is one of the risks of higher leverage. The higher the leverage ratio, the more temptation to take on new positions, given there is greater free margin available (equity minus used margin).

Initial Margin

Initial margin, which can be labelled as ‘used margin’, ‘deposit margin’ or ‘margin requirement,’ is a portion of the account equity held by your Forex broker to ensure account holders have the means to cover any potential losses. Think of this as a ‘last line of defence’ should a major event occur when an open position is active. Imagine a situation where the initial margin is 1,000 USD, and the account equity drops to 1,000 USD from 9,000 USD in a black swan event. The trader’s account is now at a 100% margin level (equity divided by used margin) and is, particularly on MetaTrader terminals, at a margin call point. Most Forex and CFD brokers will not physically call their clients to deposit additional funds. Instead, the panel within the trading terminal that includes account balance, equity, used margin, free margin, and margin percentage turns red. This is the margin call. Consequently, the 1,000 USD used margin value is your margin call. Once/if the position continues to trade unfavourably and equity moves beyond the used margin balance (this will not change), the trader or investor is at risk of connecting with the broker’s stop-out level.

Initial margin may also be defined as a ‘good faith deposit’ by some instructors. Importantly, initial margin is not a fee nor a cost and is, assuming risk is controlled, released back to the account holder once active positions are liquidated.

Is Leverage a Loan?

Finally, a common misconception about trading with leverage is that leverage is a loan in Forex and CFDs. The broker, for FX spot trading, is not lending anything. There is no loan; this is not physical share dealing. When retail traders execute a position in the FX market, a contract is formed with the broker where they believe the next move in the market will be, generally for speculation purposes. Retail traders are not physically buying euros and selling dollars in a EUR/USD (a widely traded currency pair which pairs the euro against the US dollar) long trade; this is an unleveraged transaction. Retail Forex traders and investors that trade with margin accounts set contracts with their broker. Period.

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