3. Margin and Leverage
Lots and Position Sizes
Currencies are traded in units of currencies which are grouped in lots. At a retail level, lots are divided into several categories: the so-called "full-size" or "standard" lots, "mini" lots, "micro" lots and "flexible" or "fractional" lots.
A standard lot consists of 100,000 units of whatever the base currency in the currency pair is. A mini lot consists of 10,000 units of the base currency and a micro lot 1,000 units of the base currency.
As you can see, a mini contract is one-tenth the size of a standard contract and the micro lot one-tenth of the mini lot.
Flexible lots, in turn, allow the trader to choose the exact amount of units of the base currency to buy or sell.
So for instance, when buying one micro lot on the GBP/USD, you would buy 1,000 British Pounds and sell an equivalent amount of US Dollars.
Let's suppose the current exchange rate for GBPUSD is 2.4500 and you want to buy 10,000 US Dollars worth of this pair. Here's the math:
For pairs with USD as the quote currency, take the Dollar amount you want to purchase and divide it by the exchange rate:
that is:
As you can see, this is approximately 4 micro lots of British Pounds. If your broker-dealer doesn't offer fractional lot sizes you can always round up or down.
Buying a pair with USD as the base currency is much easier to calculate. Why? Because in these cases you just buy the amount of units you want because you are purchasing US Dollars, the base currency.
And in the case of a cross pair transaction, when buying 10,000 US Dollar worth of GBPCHF, for instance, we purchase 4081.63 units of GBPUSD at the above rate and sell 10,000 units of USDCHF.
Being able to choose among several lot sizes is a huge advantage retail Forex trading offers to the small investor. It allows you to tailor and fine tune your money management to better meet your trading style.
If you have a very small account size keep your risk profile low by choosing a dealer that offers micro or fractional lot sizes. Even many seasoned traders avoid standard contracts to be more precise in their position sizing. We will extensively talk about position sizing and money management in other units of the Learning Center.
Can I still trade currencies if the lot sizes are much superior to my account size? Yes. And not only that: by trading whatever size of lots you will gain or lose profits as though that money was in your account. Making use of the leverage effect permits a trader to control a large amount of capital with a comparatively small amount of capital. This is called margin trading.
Nevertheless, margin trading is a double-edged sword: it can lead to large gains but conversely it can cause large losses if the exchange rate moves against the anticipated direction.
The Concept of Leverage
A very extended and poor definition of leverage is that it's a tool that will help traders earn money fast and easy. And indeed, one of the most important advantages of the Forex market is given by the effect of leverage! Without leverage, it would be very difficult to accumulate capital by trading the market, especially for small investors. But leverage can also be very harmful if not properly understood. This duality is what makes this concept difficult to grasp and explains partly why there are so many misconceptions about it.
Financial leverage, meaning a purchase on a margin, is the only way for small investors to participate in a market that was originally designed only for banks and financial institutions. Leverage is a necessary feature in the Forex market not only because of the magnitude of capital required to participate in it, but also because the major currencies fluctuate on average less than 2% per day.
Without leverage, the Forex would not attract capital from the retail sector. It is designed to allow a greater market share to investors in accordance with their investment capacity.
Leverage is therefore a form of credit or loan, which allows us to trade with money from the broker-dealer. Financial leverage is also defined as the use of foreign capital per unit of capital invested.
In fact, the mechanism of leverage is what enables the existence of broker-dealers. They also have accounts in different banks which serve them as liquidity providers, thus acting as lenders of first resort for the broker-dealer's margin transactions. This means that the bank allows the broker-dealer to trade with larger amounts of capital and the broker-dealer, in turn, transfers this benefit to the user. The capital deposited in the bank guarantees limited risk, as does your deposit with the broker-dealer.
Margin Trading
When conducting a Forex transaction, you are not actually buying all that currency and depositing it into your account. Technically, you are speculating on the exchange rate and contracting with your broker-dealer that they will pay you, or you will pay them, depending if the exchange rate moves in your favor or not.
A trader who purchases a USD/JPY standard lot does not have to put down the full value of the trade (100,000 USD). But to gear up the trade size to institutional level, the buyer is required to put down a deposit known as "margin". The minimum deposit capital varies from broker to broker and can range from $100 to $100,000.
That is why margin trading can be seen as trading with borrowed capital– it's basically a loan from the broker-dealer to the trader, but based on the trader’s deposited amount. Margin trading is what allows leverage.
In the above example, the trader's initial deposit serves as a guarantee (a collateral) for the leveraged amount of 100,000 USD. This mechanism insures the broker-dealer against potential losses. As you see, you are not using the deposit as a payment or purchase of currency units. It is rather a good-faith deposit, made by the trader to the dealer or broker.
When executing a new trade, a certain percentage of the deposit in the margin account will be frozen as the initial margin requirement for the new trade. The quantity of required margin per trade depends on the underlying currency pair, its current exchange rate and the number of lots traded. Remember, the lot size always refers to the base currency. The frozen initial margin requirement may not be used in trading until the trade is closed.
The more positions are opened simultaneously the more margin is required until it eventually becomes a notable percentage of your account.
Now you may feel tempted to recover the previous loss with a 50 pips gain trading with 6 mini lots. But if the trade loses another 50 pips, you will have lost $300. With the remaining $400, you may think in recovering the initial deposit trading 4 mini lots, and go for 150 pips, and so on... With each loss a recovery becomes less and less feasible because of the increase of leverage.
Leverage is the main reason why so many novice traders (and not so novice) are swept from the market. Combining their small accounts with ultra high leverages, they are an easy prey for the less leveraged and professional traders.
The belief that leverage can offset losses with big gains leads many aspiring traders to increase leverage when they experience a series of losses. Typically, the account will suffer a substantial loss. When these losses drain the account to less than the minimum margin account level, the broker-dealer will close the position and leave them with whatever is left in the account. This is how to "blow up" an account.
Margin Call - a Guaranteed Limited Risk
In the futures market, a losing position may go beyond the deposited margin, and the trader will be liable for any resulting deficit in the account. In Forex this will not happen as the risk is minimized through the mechanism of a "margin call".
Most online trading platforms have the capability of automatically generating a margin call when your margin deposits have fallen below the required minimum level because an open position has moved against you.
In other words, when the losses exceed the deposit margin, all open positions will be closed immediately, regardless of the size of positions held within the account.
Because you can never lose more than what you have deposited in your brokerage account doesn't mean that you don't have to manage your risk. It's important to take time to understand the risks associated with margin trading. Make sure you fully understand the mechanism, and in case there is anything unclear to you, be sure to ask your broker-dealer about its margin conditions.
Can the available balance be used as margin to open further positions? Usually broker-dealers allow you to use your available balance (deposit +/- open trades) as a collateral to open further positions, allowing thus to use as further margin those funds from unrealized positions in benefit. This strategy has its inherent risks because a reversal in your positions, turning them into negative territory, can rapidly originate a margin call. Should a margin call occur, make sure that you are left with more capital in your account balance than what you had before opening the positions. You can manage your positions in such a way that despite of a margin call you are left with more capital than in the beginning. For more adanced lessons on position size optimization, please see Chapter C03.
Leveraged Trading
Trading currencies on margin lets you increase your buying power. If you ask your broker-dealer what their margin requirement is for a standard lot they will give you a relatively small amount, typically $1,000. When you trade with $5,000 in margin and you control 5 standard lots worth of $500,000, that’s a 100:1 leverage, because you only have to post one percent of the purchase price as collateral.
This means the trader has to have at least $5,000 ($5,000 + spread to be more precise) in the margin account to trade 5 full size lots.
Now you understand why the rollover amount will depend on the size of the transaction: with higher leverages, the interest differential the broker-dealer pays or charges will proportionally increase, because you are controlling a larger amount of currency, even if you don't have that amount in your account.
The normal margin requirement is between 1% and 5% of the underlying value of the trade, that is a leverage between 100:1 and 20:1, although some broker-dealers provide extreme levels of 200:1 (0.5%) and more. Most dealers scale their margin requirements which allows smaller accounts to use higher leverages like 200:1, and bigger accounts to use 50:1, or 10:1.
The currency denomination for the leverage depends on the brokerage through which you execute your trade, but it is usually US Dollars.
Despite being very attractive for small investors, leverage is one of the main reasons people lose money trading Forex. The purpose and use of leverage can be a difficult subject to understand, but it's mandatory if you want to avoid the traps it may represent. It is not in your interest to misuse the concepts of margin and leverage. Professional traders are very careful about it- that is why they stay in the market in the long term.
A common way to calculate the margin required per trade is the following: suppose you have 100:1 leverage from your broker-dealer. The maximum trade size is then calculated as amount in USD x 100. Supposing you decide to buy one standard lot of GBP/USD. To figure out the amount of capital which has to be set aside as margin for the value of the deal, we need to take the current rate for GBP/USD (let's say 2.0200) and do the following:
Should the account balance equal or drop below the margin requirement, the broker-dealer would liquidate all open positions on a margin call. That means that using $2020 in margin and trading one standard lot with $10,000 in the account, if the trade would go negative by $7981, a margin call would occur.
THEN
$10,000 – $7,981 = $2,019 < $2,020 → margin call!
In reverse quote pairs, the currency denomination for the leverage is already in USD. In the case you would decide to buy a standard lot of USD/JPY at a rate of 105.00, then you would need a $1,000 margin for a $100,000 lot with a 100:1 leverage.
Let's say you have an account with $10,000 and you open that USD/JPY position. The broker-dealer won’t automatically close the trade if the losses exceed $1,000. The margin call will occur only when your net balance is less than $1,000. So if the position goes against you and accumulates $9,001 worth of losses, your position will be automatically closed and you will be left with $999 in your account.
Broker platforms already include the spread and the rollover into the equation, but remember that these variables also influence the net balance.
Dirk Du Toit insists a lot on explaining this subject to his students. In his book, “Bird Watching in Lion Country”, he states:
Margin required and leverage is not the same thing. "Low margins" ="low margin requirement" ="high gearing". You do not trade with 100:1 leverage or 1%. Your margin required is 1%. If you go broke your broker will allow you to trade up to 100:1.
Let me explain the problem with an example of half-percent margin. A prominent market maker offers "$1.000" lots and "$500" lots. You have $10.000 and you use 1% margin on the $1.000 lots. What's your percentage?
Write it down here ____or hold the thought. You make $300 Dollars on a trade and decide this is too easy. You arrange to pay the $10.00 fee and trade on 200:1 leverage or "$500 lots."
You have $10.300 and you now use 1% margin on the $500 lots. What's your leverage? Write it down here ______or hold the thought.
The total is $1.000, still only 10% of your capital accounrequired for margin, what's the problem?
The problem is that it is a false concept to express risk as a ratio of "margin required" to "capital on margin". It is an illusion that your risk was the same, yesterday and today.
Yesterday you traded $100.000, i.e. you levered your money 10:1 (for each one Dollar you have you trade as if you have ten). Today you traded $200.000, i.e. you levered your money 20:1 (for each Dollar you have you trade as if you have twenty). All it means is the time it takes for the guillotine to drop has been halved. You can be deceived by lots of $1.000 and risking "only 10% of your capital". You don't risk only /10th of your capital, you risk your capital 10 times.
The Assessment modules in the Practice Chapter A contain more than 250 questions, and many of them insist on the issue of leverage. These educational resources aim to train the trader for real case scenarios by applying the theory explained in the Learning Center.
Effective Leverage vs. Maximum Leverage
On one hand traders can exploit the maximum margin requirements that the broker-dealer provides, which can range from 100:1 to 400:1, but on the other hand we have the technical aspect of the mechanism. When asking what leverage you are using in your trading, you have to refer to the leveraged amount which you are effectively using to enhance your trading strategy.
The effective leverage is of paramount importance. There is nothing wrong in choosing the maximum level of leverage that the broker-dealer allows. What can put a trader in a dangerous situation is when the effective leverage comes close to the maximum displayed by the broker-dealer.
The effective leverage is calculated by dividing the value of open positions by the available balance of the account. In other words, the real leverage is the amount of capital you are really using compared to the amount in your account.
With a position worth of $20,000 (2 mini lots) and an account balance of $1,000, the real leverage is 20:1 (20.000/1.000 = 20). If this trade loses 50 pips, the account balance would go down by 10%. Remember, the pip value would be $2,00, multiplied by 50 pips, that is $100.
Should this loss happen, the real risk would increase with the next trade - now a loss of $100 is 11% of the account. This also means that the effective leverage rises even if the position size is kept the same, because the account balance is now lower. This is the typical dynamic of a losing spiral we mentioned when traders blow up their accounts - by doing the same, they lose more with each trade. This is because leverage increases each time.
To compound the issue, if the trader increases his/her leverage deliberately thinking in recovering losses faster, he/she is not acting in his/her best interest.
A leverage of 20:1 in a single position is quite high if we are to stay in the market for the long run. If our method is efficient in terms of consistency, then we can fine tune the leverage to get the maximum profit from it. This doesn't mean to exploit the maximum leverage offered by the broker-dealer, but instead, to use the maximum leverage that our method can sustain without the danger of a margin call.
For instance, you can have 5 open positions with an effective leverage of 4:1 each one. This way, you arrive at a leverage of 20:1 by adding 5 positions, and you will be eventually better protected with multiple positions over different currencies, than betting that leveraged amount in just one currency pair. The same leverage of 20:1 spread over several positions is a measure to diversify your risk.
How to bring this into practice will be discussed further when studying the development of trading systems and money management techniques. For now let's take one more step in the appliance of the mechanics you have just learned.
A lack of understanding of trading mechanics can lead you to damage your account unintentionally. Don't wait to be confronted with these fine aspects when incurring errors. Expose your doubts and share your experiences in our social network.
