Understanding Forex Margin and Leverage
What is Margin?
Using margin in Forex trading is a new concept for many traders, and one that is often misunderstood. Margin is a good faith deposit that a trader puts up for collateral to hold open a position. More often than not margin gets confused as a fee to a trader. It is actually not a transaction cost, but a portion of your account equity set aside and allocated as a margin deposit.
The advanced dealing rates window, found in the FXCM Trading Station pictured below, will show you specifically how much margin is required to hold open one 10k position in a standard trading account. It is important to remember that this value represents one trading lot and that the amount of margin needed to hold open a position will ultimately be determined by trade size. As trade size increases your margin requirement will increase exponentially.
What is leverage?
Leverage is a byproduct of margin and allows an individual to control larger trade sizes. Traders will use this tool as a way to magnify their returns. It’s imperative to stress, that losses are also magnified when leverage is used. Therefore, it is important to understand that leverage needs to be controlled.
FXCM provides flexible leverage to its clients. You can trade with no leverage at all, or you can trade with a significant amount of leverage based off of your personal preferences. Let’s look at an example using effective leverage
Let’s assume a trader chooses to trade one mini lot of the USD/CAD. This trade would be the equivalent to controlling $10,000. Because the trade is 10 times larger than the equity in the trader’s account, the account is said to be leveraged 10 times or 10:1. Had the trader bought 20,000 units of the USD/CAD, which is equivalent to $20,000, their account would have been leveraged 20:1.
Effects of leverage
Using leverages can have extreme effects on your accounts if it is not used properly. Trading larger lot sizes through leverage can ratchet up your gains, but ultimately can lead to larger losses if a trade moves against you. Below we can see this concept in action by viewing a hypothetical trading scenario. Let’s assume both Trader A and Trader B have starting balances of $10,000. Trader A used his account to lever his account up to a 500,000 notional position using 50 to 1 leverage. Trader B traded a more conservative 5 to 1 leverage taking a notional position of 50,000. So what are the results on each traders balance after a 100 pip stop loss?
Trader A would have sustained a loss of $5,000, loosing near half their account balance on one position! Trader B on the other hand fared much better. Even though Trader B took a loss off 100 pips, the dollar value was cut to a loss of $500. Through leverage management Trader B can continue to trade and potentially take advantage of future winning moves. FXCM believes clients have a greater chance of long-term success when a conservative amount of leverage is used in their trading. Here is a recent study completed of thousands of FXCM accounts (“Traits of Successful Traders: How Much Capital Should I Trade Forex With?”). Keep this information in mind when looking to trade your next position and keep effective leverage of 10 to 1 or less to maximize your trading.
---Written by Walker England, Trading Instructor
To contact Walker, email firstname.lastname@example.org. Follow me on Twitter at @WEnglandFX.
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