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MARGIN & LEVERAGE

Margin and leverage are two most important things you need to understand if you want to trade forex and CFD's. Margin and leverage allow you to increase your exposure to the instrument or asset and thus be able to control larger positions. While margin and leverage can help you to increase or magnify your profits, if not used properly, margin and leverage can also result in huge losses.

The information contained in this page gives you an overview of margin and leverage and why they are important for traders.

WHAT IS MARGIN?

Margin is defined as the collateral that a trader needs to deposit with the broker to cover the trading risks. When you trade on margin, you are essentially borrowing money from the broker to purchase the instrument or asset. Think of margin as a loan from your brokerage. The benefit of using margin is that you are able to buy more units in the instrument than you normally would.

Margin is easier to understand with the following example.

EXAMPLE 1

Let's say you want to buy a car that costs $10,000. But you only have $5000. Your car dealer offers you a loan, but requires you to make an initial payment. In this case, you pay the $5000 as collateral, which is nothing but margin.

This simple everyday transaction, as you can see is nothing but buying on margin. With only $5000 you were able to afford a car that costs twice the amount

WHAT IS LEVERAGE?

Leverage is a subset of Margin. Leverage is nothing but the ratio between the margin and the value of the asset. At JDFX, we offer a leverage of 1:100. What does this mean?

A leverage of 1:100 simply means that for $1 in margin, you can control $100 of the unit. Leverage can also be represented as a percentage. A leverage of 1:100 is nothing by 1%, 1:50 is 2%, 1:20 is 5%. 

Let's go back to the previous example.

EXAMPLE 2

So you bought a car with an initial deposit (or margin) of $5000. The car is valued at $10,000. The leverage here is 1:2. This ratio is derived by the initial margin and the total value. Thus, a 1:2 ratio (or leverage) allows you to control $2 for every $1 in margin. If you do the math this comes to $5000 in margin to control (or purchase) the car valued at $10,000.

MARGIN & LEVERAGE IN FOREX

With the above understanding, let’s look at how margin and leverage can impact your trading.

EXAMPLE 3

You deposit $1000 in your account, and you want to trade 0.1 lot which is 10,000 units. Say you want to go long on EUR/USD, which is trading at 1.10000. A 0.1 lot position in EURUSD = 10,000 x $1.10000 = $11,000. But notice that you only have $1000 in your account. Now let’s add leverage of 1:100, which means that you can control $100 for every $1 in margin. Applying this to your account balance of $1000, you can now effectively control $100,000. Thus, you can now buy 0.10 lots in EURUSD. In this example, the margin to maintain the long position in EURUSD would be $110.

This value is derived from the following calculation:
Margin = (Lots x Price) / Leverage [$110 = (10,000 x $1.10000)/100]

You can also trade bigger lots on margin. For example, let’s say you want to trade 0.5 lots (50,000 units). Then, the calculation is: (50,000 x $1.10000)/100 = $550 As you trade bigger lots, your margin requirement also increases

HOW CAN MARGIN & LEVERAGE HELP YOU MAKE PROFITS?

Depending on the leverage, your profits can also increase at the same pace.

Forex prices are quoted in 5 decimals. Therefore a 22 point move is nothing but 2.2 pips. For 0.1 lots, this is equal to $2.20.

Now if you exit your long position after price moves 500 points, which is 50.0 pips, then 0.1 lot is equal to $50.0.

When you trade responsibly on margin, you can effectively increase the point value of your trades.

WHEN DOES MARGIN AND LEVERAGE BECOME RISKY?

Margin and leverage can be risky when you ignore the following rules:

  You do not understand margin and leverage and start trading bigger lot sizes on margin

  When you trade bigger lot sizes, the margin requirements increase, this leaving the available balance at a minimum

  If price moves strongly against your position, you can risk a margin call

  A margin call is where your trading balance falls below the minimum requirements. To avoid a margin call, you need to adequately fund your account, failing which the positions are liquidated (usually at a loss)

MARGIN CALL & STOP OUT

A margin call is merely a warning from your broker informing you that you need to deposit additional funds if you want to maintain your open positions.

A stop out is where your positions are automatically closed.

Margin call and stop out levels are represented in percentages:

  Margin call is calculated as Account Equity = Required margin times x%

  Stop out level = Required margin times x%

Different brokers have different margin call and stop out levels. At JDFX, the margin call is set to 100% and stop out level is set to 50%.

It is absolutely essential that you keep an eye out on the margin and stop out levels as it is the responsibility of the trader to maintain adequate liquidity in their trading accounts.

EXAMPLE 4

Margin Call: 100% Stop Out level: 50% Going back to example 3 where the required margin is $110 A 100% margin call is $110 = $110 x 100% So, when your account equity falls to $100, you get a warning from the broker. A 50% stop out level is when your account equity falls to $55; your positions are closed out.