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Leverage and Margin

By Thomas Long, Course Instructor
14 October 2009 00:54 GMT

Leverage and margin is a very important concept to understand, because leverage can get you in trouble pretty quickly if not used properly.  That being said, if leverage is applied properly, it can increase the profitability of your trading strategies.


“Leverage” and “margin” refer to the same concept, just from a slightly different angle.  When a trader opens a position, they are required to put up a fraction of that position’s value “in good faith”.  In this case, the trader is said to be “leveraged”.  The amount that is required to be put up is known as the “Margin Requirement”.  The margin requirement is often referred to as a “good faith deposit”, because the trader generally gets all of that that amount back when they close the position out.   I say “generally” here because it may not be the case in the event of a Margin Call, which will be described in more detail later.


Just to be clear: margin deposits are a requirement for trading, not a cost of trading.


A major benefit to the FX market is that it offers some of the lowest margin requirements of any tradable financial instrument.   This means that the purchasing power of your account is much higher than that of an equities trading account or bond trading account of the same size.


                                        leverage 1
Let’s go through an example of leverage and margin.


Suppose a trader opens up a position of 1 10k lot in the USD/JPY pair.  The trader wouldn’t have to put up $10,000.   They would only have to put up $50 or maybe $100.   (exactly how much would depend on what level they had their account set at.)   Our Demo accounts default to 200:1 leverage so a 10k position would only require $50 in margin requirement (which is 0.5% of 10,000).  If the trader opened a two 10k lot positions, their total position would be 20,000 and the margin requirement would now be $100.


One important note here is that the margin requirement is not the maximum you can lose on the position.   It is simply what the broker requires you to put up in order to open a position.   You’ll always want to keep in mind the actual size of your position because your profit and loss will be based on the size of the position, not on the amount of margin required.


The table below will provide some additional examples.


                                        leverage 2

A trader should always keep in mind that leverage is a double edged sword:  while high leverage can magnify gains as a position moves in your favor, it will also magnify losses as a position moves against you.


For that reason it is important not to overleverage your account by either placing too much of the account value at risk and/or opening too many positions relative to the size of the account.


Exactly how much is too much is up to each trader.  Short term traders are generally comfortable using more leverage because they know that the position won’t be open very long.  Longer term traders will want to use less leverage so that small fluctuations don’t wipe them out.  We suggest trying different leverage amounts with your trading strategy on a demo account to find what works best for your trading style.  Remember, just because you have access to a great deal of leverage doesn’t mean you should always use it.

To make things very easy for traders, FXCM posts the Minimum Margin Requirement (MMR) for each pair in the Simple Dealing Rates Window. 
 

leverage 3

This table will show you the dollar amount required in margin to open one lot of that pair.


I also want to draw your attention to the Accounts window. 

leverage 4


In this window the platform will display the Usd Mr which stands for “Used Margin”.  This is the amount that is currently set aside as the “good faith deposit” for your existing positions.  The column to the right of Usd Mr is Usbl Mr.  Usbl Mr stands for “Usable Margin”.   This is how much you have left to support your current open positions, or how much you have available to open additional positions if you’d like.  Next to that is Usbl Mr %.  This shows you the percent of your account equity that is Usable Margin.  If Usbl Mr, % ever goes to 0%, a Margin Call will be triggered on the account.   A margin call means that the equity of the account is not enough to meet the minimum margin requirement for the positions that are open.  When this happens all open positions are immediately closed at the current market rates.


FXCM guarantees that no account can go into negative territory.  If the market moves so quickly in the wrong direction that an account is left with negative equity, FXCM will make an adjustment to the accout to bring it back to Zero.  No FXCM client can lose more then what they have deposited into their account.


That being said, we never want a Margin Call triggered on our account.  It is often a very serious blow to your trading confidence, as well as likely being very expensive!  So it is important keep an eye on our Usbl Mr, % column to make sure it never falls to zero, and to be careful not to overleverage your account. 


As I’ve said,  leverage can help maginify gains as well as losses.  Using leverage apporpriately can help make sure it is more of the former and less of the latter.

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14 October 2009 00:54 GMT