Foreign Exchange Market Online Trading: Margin & Leverage

Picture of teeter totter with words ‘Margin and Leverage’ and ‘Forex’ above and below it.

Hi friend! You are trying to understand the basics of trading the forex market, but it is still a struggle for you. In this blog post, I am going to de-mystify two commonly misunderstood aspects of forex trading, and unravel the mechanics of trading forex pairs.

Accordingly, I have labelled this blog post Foreign Exchange Market Online Trading: Margin & Leverage.

You will find the Table of Contents by clicking here.

Prologue

If your interest lies elsewhere, other than the forex, be sure to check out my blog post summaries. There might be something in there that stirs your imagination. Here is the link:

https://www.tradingsmarts.com/blog/

There you will find stock market trading strategies, as well as foreign exchange market trading characteristics, and foreign exchange market trading strategies.

You may be particularly interested in foreign exchange vs stock market trading, in which case you should check out:

https://www.tradingsmarts.com/currency-trading-strategy/

Forex Tip

With foreign exchange market online trading, you will find that spreads vary from broker to broker and by currency pairs at each broker as well. In general, the most liquid pairs have the tightest trading spreads and fewer sudden price movements. The less liquid the currency pair, the wider the spread. This is especially true of some of the less-traded crosses.

It is to your advantage to trade when there is peak liquidity and market interest, as this is when short-term forex trading strategies are the most effective.

You will find that market liquidity is the most robust during the European session, which runs from approximately 2 am Eastern Time (ET) to noon Eastern Time (ET). This is when the Asian and North American trading centres overlap with European time zones.

I call this the London session, where you will find significant price action in and around the London open (3 am ET) and the London close (11:30 am ET).

I know of a forex trader in the Seattle area who only trades the London close, and does quite nicely at that time.

Trading during other forex time zones may leave you somewhat disappointed with the anaemic price action during those times.

For the best forex time zones to trade, please check out this blog post:

https://www.tradingsmarts.com/forex-wealth/ (Forex Wealth Strategy #3).

There you will find the best foreign exchange market hours.

Table of Contents:

Prologue
Forex Tip
Getting at the Truth
Leverage
Leverage/Margin Explained
Risk Formula
Common Misunderstanding
More on Margin & Leverage
In Sum
How Margin Ratios Work
Profit and Loss
Mark-to-Mark Calculations
Trade With Eyes Wide Open
Trading Pairs Mechanics
One Extra Decimal Number
Inspiration
Forex Tools
References
Conclusion

Getting at the Truth

Picture of words ‘FALSITY’ & ‘TRUTH’ with title ‘Getting at the Truth’ at top left corner.

You may be struggling with the whole concept of margin and leverage in the forex market.  They’re not the easiest concepts to grasp.  I know it took me a while to get my head around them.

In case you are not familiar with the functions of the forex market, here is a brief foreign exchange market definition… it is the market in which the various players are able to buy, sell, exchange and speculate in currencies.

Foreign exchange market participants comprise banks, central banks, commercial companies, institutional investors (a.k.a., the ‘Big Dogs’), investment management firms, hedge funds, investors, ‘noise traders,’ and retail forex brokers.

In terms of foreign exchange market efficiency, it is the most efficient of markets, putting in ~US$5.3-trillion a day

Before we get to the nub of margin and leverage, a member asked me how much a trade costs.  It has more to do with the mechanics of margin and leverage, which you will better understand as you read on.

I’m going to dive right in.  If you get overwhelmed, hang in there, as the going gets easier, as you progress through this blog post.

You may wish to click through to the In Sum section first, and then backtrack. 

Let’s get started, so that I can sort fact from fiction.

Leverage:

Let’s explain leverage in terms of all three possible lot types, be they standard, mini, or micro.

I’ll start off with an account size of US$35,000 and later on work with a smaller account size (US$2,000).   

Assume an account size of US$35,000 with 2% risk per trade, 30-pip stop loss, 20-pip profit per lot, and trading with 100:1 broker-offered leverage.  True leverage is trade size divided by account size; therefore, leverage is not 100:1.

US$35,000 x 2% = US$700 risk per trade 

One standard lot controls US$100,000.  

Regular Account (1 pip EUR/USD = US$10):  US$700 divided by US$300 (30-pip stop for a regular account) = 2.33 (2) regular lots you can trade.  You are trading a US$200,000 (2XUS$100,000) trade size for 2% risk on your US$35,000 account.  Your trade is levered at over 5:7 (US$200,000 divided by US$35,000).  Your profit is 20 pips times 2 regular lots = US$400 profit.

One mini lot controls US$10,000.

Mini Account (1 pip EUR/USD = US$1.00):  US$700 divided by US$30 (30-pip stop loss for a mini account) = 23.33 (23) mini lots you can trade.  You are now trading US$230,000 (23XUS$10,000) for 2% risk on your US$35,000 account.  Your trade is levered at over 6:6 (US$230,000 divided by US$35,000), but you’re still not risking any more than 2%. And, even if your 30-pip stop is hit, the risk is still the same.  Your profit is 20 pips times 23 mini lots = $460 profit (more than with a standard account).

One micro lot controls US$1,000. 

Micro Account (1 pip EUR/USD = US$.10):  US$700 divided by US$3.00 (30-pip stop for a micro account) = 233.33 (233) micro lots you can trade.  You are now trading US$233,000 (233XUS$1,000) for 2% risk on your US$35,000 account.  Your trade is levered at more than 6:7 (US$233,000 divided by US$35,000), but you are now able to trade US$233,000 on this trade – for the same amount of risk. Your profit is 20 pips times 233 micro lots = $466 profit.  And now, you’re getting an even bigger bang for your buck than with mini and standard accounts!

For 20 pips profit, using the same amount of risk, you would have made:

On a regular account = US$400 profit
On a mini Account = US$460 profit
On a micro Account = US$466 profit

Translation:  With foreign exchange market online trading, you’re getting a bigger bang for your buck with mini and micro accounts, without risking any more. This is very important to understand, as it equates directly to longevity in this business, and how to grow your account the best and fastest way – which is what leverage is all about in the first place.

You will notice how, if you understand leverage and position sizing correctly, and utilize MICRO LOTS, which are just 8-10 cents a pip (depending on the pair), you can grow your account faster and smarter by getting more mileage for your money – still protecting your account balance, which is the first rule of trading.

Okay, now that you hopefully understand the three types of lots, let’s consider just one more example using the micro lot and a smaller account size. 

One micro lot controls US$1,000.

US$2,000 (account size) x 2% = US$40 risk per trade 

Micro Account (1 pip EUR/USD = US$.10):  US$40 divided by US$3.00 (30-pip stop for a micro account) = 13.33 (13) micro lots you can trade. You are now trading US$13,000 (13XUS$1,000) for 2% risk on your US$2,000 account.  Your trade is levered at 6:5 (US$13,000 divided by US$2,000), but you are able to trade US$13,000 on this trade – for 2% risk.  Your profit is 20 pips times 13 micro lots = $260 profit.

The key takeaway is, with a US$2,000 account size, trading micro lots, and applying the 2% risk parameter, you are able to trade upwards of 13 lots.  

I recommend that you strive for 20 pips (that’s where the 20 pips comes from) a day which, in a standard account, translates into US$4,000 per month – which is more than most people make in their day jobs. 

As far as the 2% is concerned, that comes from my personal belief that you should never risk more than 2% of your trading capital on all trades in play.

As to the 30-pip stop placement, that is where I recommend you place your stops, unless you are trading longer-term, in which case you should use a wider stop.

Leverage/Margin Explained:

With 100:1 leverage, margin is 1%, meaning that, to control US$100,000 (standard account), you would need US$1,000; to control US$10,000 (mini account), you would need US$100; to control US$100 (micro account), you would need $10.

US$1K initial margin controls US$100K (one standard lot), or ten mini lots.

Risk Formula

According to one trader, he uses the risk formula of 1.5% account risk per trade.  With an average stop of 30 pips, that means that, to take a US$100K position, for example, his account equity needs to be US$20K (30 pips equals = US$300, which is 1.5% of account equity @ US$20K, or US$10 per pip risk).  Or, to put it another way, his selected leverage in that scenario (or multiples thereof) is actually 5:1 (US$20K equity to US$100K position sizing).

Canadian FX brokers must abide by the IIROC margin requirements which, for a pair like GBP/JPY, is 6.4% (converted to USD, closer to 10%).

Common Misunderstanding

Picture of magnifying glass over the word ‘facts’ repeated many times.

This commentary was prompted by a remark I heard in a forex user’s group meeting about foreign exchange market online trading:  “I want to trade with the broker that gives me the highest leverage possible.”  

Leverage in the forex market simply means to borrow money to trade.

Let’s suppose you have a $2,000 mini account, and you go long one lot of USD/JPY.  One mini lot controls $10,000 of currency, meaning you are borrowing $10,000 from your broker, secured by your $2,000 account balance.  Mathematically, the equation to calculate leverage is:

Transaction Value / Account Balance = Leverage

Expressed as a ratio:  thus, $10,000 / $2,000 = 5

So, in your trade, you are leveraged at 5:1

Given your understanding that your broker advertised 200:1 leverage, let’s see what happens, if you trade at that leverage.  Using the same equation, let’s see how many lots you could trade.

Transaction Value / $2,000 = 200

Solving for Transaction Value yields $400,000 (2,000 times 200). 

Remember, one lot is worth $10,000.  So, you are trading 40 lots (400,000 divided by 10,000).

If you follow the general rule of thumb that says, don’t risk more than 3% – 5% of your assets (I say 2%) on any one trade (lets use 4%), you need to hold your risk to 4% of $2,000, which amounts to $80.

Given you have 40 lots, your risk (controlled by your stop) can be no more than 2 pips (80 / 40).

Perhaps you won’t even be able to place this trade, if that is equal to or less than your broker’s spread.

Or, to look at it another way, you will likely get stopped out with a stop only 2 pips away from your entry

Consider this trade with the same $2,000 mini account – again, you are going long one lot of the USD/JPY.

But now, with $80 as your risk (same 4% of your assets, as before), you can go as high as 80 pips for your stop (each pip is worth a dollar for a mini account).

Ultimately, your trade turns out to the good.  Your profit is 100 pips, or $100 on a trade that controlled $10,000.  That’s a 1% return.

Not exactly a killing but, looking at it another way, on the $2,000 you invested, your return is actually 5% (better than what you can get at the banks these days).

Not too shabby for a single, small trade, probably over a short period of time – not to mention the power of compounding.

Just think where you could be, if you could pull this off a couple times a week with just 5:1 leverage.

In sum… leverage, from a broker’s perspective, is the maximum borrowing allowed in your account.

If the leverage is advertised as 200:1, that means you are allowed that, and no more.

That does not mean, however, that you have to trade with that amount of leverage.

Through the eyes of the trader, leverage is the value of your transaction divided by the value of your account, expressed as a ratio.

That means that you can trade at any leverage your heart desires, up to the maximum permitted by your broker.

You control leverage by the choosing the number of lots to trade and the amount you put in your account.

(Info via Dick Thompson)

More on Margin & Leverage

As regards foreign exchange market online trading, you start your journey by maintaining funds in your trading account at your broker-of-choice.  

These monies are ordinarily segregated in trust – often as dictated by the legal authority under which your forex broker operates.

Your broker often mandates account minimums.  

To enter and maintain a trade, you need to commit some of your trading account (called ‘margin’).  The trading account itself is sometimes referred to as a ‘margin account.’

The amount of margin you allocate to a specific trade is a percentage of the trade value, expressed as a ratio (called ‘leverage’).

Leverage ratios can vary from 1000:1 (that’s not a typo) to 10:1 (with 50:1 being the norm in the U.S., as mandated by the Dodd-Frank legislation).  You must reserve 1% of the trade value as margin, should the ratio be 100:1.

Let’s suppose you go long a full size lot for the USD/JPY pair.  The value of that trade is US$100,000 (standard lot).  

If the leverage offered by the broker is 50:1, you must commit and maintain 2% of the trade value in your margin account, or $2000.

If the USD/JPY trade goes in your favour, your account balance will appreciate by the amount of the increase, thus facilitating you being able to do more trading.

If, on the other hand, your trade swoons, even if only for a short while, you must allocate additional margin funds to your trade. 

This has the net effect of reducing your account balance, thus leaving less margin funds available for other trades.

Should your trade result in losses that exceed your account balance, the forex trading platform will more than likely collapse the position automatically, unbeknownst to you.

(Info via Investopedia)

In Sum

Regarding foreign exchange market online trading, be sure to thoroughly vet whichever forex broker you settle on.

In order to start trading the forex at a broker, you have to establish a funded account, called a margin account.

This initial margin balance is henceforth considered collateral that abides by the posted margin requirements of your broker, and is the basis upon which all trades are collateralized.

Beyond that point, your broker will not issue any margin calls (i.e. request further collateral to keep open positions active).  This is unlike margin-based equity trading or futures markets.

Instead, your broker will hold you to its required ratio of margin balances to open positions. 

Should you let that ratio slip, your broker is within its rights to close out your positions without notifying you.

If this happens, that usually translates into losses being realized, thereby reducing your margin balance.

With some brokers, all positions are liquidated, in the event you let your margin account fall below the required margin ratio.

With other brokers, they will ensure that the required ratio is re-established by closing out the largest losing positions, or portions thereof.

What this all amounts to for you is that you thoroughly understand your broker’s margin requirements and liquidation policies by reading the fine print in the account opening contract before you sign on the dotted line.

Requirements will usually be dictated by account size and the account types you will be trading – be they standard lot sizes (100,000 currency units), mini lot sizes (10,000 currency units), or micro lot sizes (1,000 currency units).

How Margin Ratios Work:

Okay, you have a margin account with a leverage ratio of 100:1, representing 1% margin.

In simple terms, $1 of margin in your margin account can control a position size of $100.

A margin requirement of 100% is the usual norm for small accounts with most forex brokers, although it varies with account size.

What this means, of course, is that you have to maintain 100% of the required margin at all times.

In other words, a position size of $10,000 would require that you have $100 in your account – $10,000 divided by the leverage ratio of 100 is $100.

(Info via FOREX.com – Brian Dolan, GAIN Capital Group – Mark Galant)

Profit and Loss

Picture of man holding words ‘profit’ and ‘loss’ up in the air.

Mark-to-Mark Calculations:

The real-time mark-to-market calculation shows your unrealized P&L and margin balance.  This is determined by where you could close your open positions in the market on the spot.

This feature is offered by most forex brokers, but its implementation depends on your broker’s forex trading platform. 

In the case of being long, the price used will usually be determined by where you could sell at that instant.

Whereas, in a short situation, the calculation will take into account where you can buy at that moment.

Your margin balance reflects your initial margin deposit, your realized P&L, and your unrealized P&L.

Realized P&L comes from collapsing a trade in play, or a portion thereof.

When you close out a full position, your gain or loss is reflected in your margin balance, and is not factored into the unrealized P&L calculation.

If you close out only a portion of your open position(s), only that part of the trade’s P&L is realized, and the net effect gets reflected in your margin balance.

Your unrealized P&L and your margin balance continually fluctuate based on positions in play.

A winning open position translates into your unrealized P&L being positive and your margin balance increasing.

Conversely, a losing situation would see your unrealized P&L turn negative, and your margin balance be reduced.

Given that forex prices are constantly changing, your mark-to-market unrealized P&L and total margin balance change in kind.

(Info via FOREX.com – Brian Dolan, GAIN Capital Group – Mark Galant)

Trade With Eyes Wide Open:

1.	Picture of digital lady staring straight ahead with her eyes wide open.

To conclude, your online forex trading platform takes care of calculating your P&L for you automatically, be it realized or unrealized.

The P&L calculation take effect as soon as you enter a trade.

From margin maintenance and risk management points-of-view, it makes sense to know beforehand how big your position will be, how much margin you should risk, and what your P&L outcomes will be before you commit to a trade.

You can see that the P&L implications for your trading are huge.  You need to stay on top of their impact on whatever trade you are contemplating, so that you maintain your margin balance, and maintain control over your trading.

By doing so, you will live to see another trading day.  You will avoid costly mistakes, like entering a trade that is too big, or engaging stops that put your margin account in jeopardy – i.e. causing it to fall beyond the margin requirement.

You should calculate where your position would in the event of your margin balance falling below the required ratio.

(Info via FOREX.com – Brian Dolan, GAIN Capital Group – Mark Galant)

To repeat… NEVER risk more than ~2% of your trading capital on ALL of your open positions.

Trading Pairs Mechanics

The base currency is the first currency listed in the currency pair.  It is the basis for the buy or the sell. 

Example 1:  The EUR/USD is trading at 1.2400/03 (bid/ask).  You buy the euro at 1.2403.  You are now ‘long’ the euro and ‘short’ the U.S. Dollar.  The euro is the base currency for the EUR/USD (euro/U.S. dollar).

The euro goes higher to 1.2537.  You sell it there.

In summary, you bought the euro $100,000 at 1.2403 and sold the euro at 1.2537.  Your profit is .0134 (134 pips) or US$1,340 (.0134 x euro $100,000 = $1,340).  Or, stated differently, 134 pips times the pip value of US$10 = US$1,340.

Example 2:  The current bid/ask price for USD/JPY is 107.20/107.23.  This means that you could buy $US1 for 107.23 Japanese yen, or sell $US1 for 107.20 Japanese yen.  The U.S. dollar is the base currency for the USD/JPY pair (U.S. dollar/Japanese yen).

Example 3:  You sell Japanese yen.  The USD/JPY is trading at 107.20/23.  You buy at 107.23.  You are now long the U.S. dollar and short Japanese yen.

The U.S. dollar falls to 106.76.

On this USD/JPY trade, you bought US$100,000 at 107.23 and sold it at 106.76.  Your loss on this trade is .47 (47 pips) or US$440.24 (US$100,000 x 0.47 = JPY47,000 / 106.76 = US$440.24).

One Extra Decimal Number

It used to be that the pip was the smallest unit of value in the forex market. Today, however, many forex dealers quote in tenths of a pip.  They have carried out the quote one extra decimal number to give better and more accurate spreads.  For example, with 1.47253, the 3 is the tenth of a pip.

Inspiration

Show up every day, and do one small thing to improve the thing you’re measuring.  If you do this, you will be among the top 5% of achievers.  Over time, you will build a system that will trump any specific lucky breaks or windfalls, and it will get you the financial success you deserve.”  JP Livingston

1.	Picture of professional Japanese entertainer performing with his yo-yos.

Follow your passion, even if no one else cares about it.”  Black won the World Yo-Yo Contest, performed in Cirque du Soleil, and talked at a TED conference.

This is one of the most creative and famous conferences in the world and, of course, no yo-yo people had ever been on their stage before.  The pressure did not seem to faze him.  His ability would lead him to success, and he was recognized with one of the biggest standing ovations. 

He has achieved dreams, once thought impossible.  He says that, even if you don’t have any special talent, you can achieve your dreams

His show turns just a simple toy into a spectacular performance.  He started with no talent, but rose to the challenge, and made his unprecedented dream come true.

He defined his own happiness, and chased his dream, giving up a career as a systems engineer to become a professional performer.

He trained for 10,000 hours – practicing that took him to the title of world champion in just four years.  He won the World Yo-Yo Contest held in Florida, USA.  It was not achieved by his talent, but by his extraordinary effort.

He couldn’t speak English (being Japanese), but had to learn, so that he could address audiences when performing.

He even took up ballet, jazz dance and acrobatics to improve his performance.  That surprised him because, when he was a boy, he was not good at, and hated sports.

Who could imagine that just a Yo-Yo could take Black to the stage of his dreams?

Not bad for a kid who, at age 14, had lost everything, and had no vision for the future.  He started with no special abilities or talent.

His motto:  “Live our limited life, happy.”

Picture of inspirational message about changing your life.

Forex Tools

If you would like a good support and resistance MT4 indicator, it is available at the Contact link.  You can also ask for my pivot point calculator at the same link. 

A pip value calculator is available at:  http://ca.investing.com/tools/forex-pip-calculator

ProRealTime.com offers forex trading indicators, including a forex support and resistance indicator for forex pivot points, and numerous other features.

My favourite book on trendline analysis remains Tom DeMark’s ‘New Science of Technical Analysis.’

References

http://ca.investing.com/tools/forex-pip-calculator

http://www.gaincapital.com/

http://www.investopedia.com/

http://www.investopedia.com/terms/forex/f/foreign-exchange-markets.asp

https://www.forex.com/en-ca/

https://www.prorealtime.com/en/

Conclusion

I hope you found this Foreign Exchange Market Online Trading: Margin & Leverage blog post to be instructive, and that you now have a better appreciation for the concepts of margin and leverage. 

It’s a difficult discussion to be sure, but one which is necessary to understand, if you are to become a proficient forex trader.

If you are still confused about any particular discussion point in this blog post, please feel free to contact me here.

If private consulting lessons would help, you can request them at the same link.

Or, if you feel you need the help of a trading adviser, use the same link to let me know.

When you get a chance, have a read through my previous blog posts:

VIX

After Hours Trading

Trading Volume

Stock Trading Stops

Currency Trading Strategy

How to Pick Stocks

Stock Trading Rules

Three Winning Stock Trading Strategies

Forex Trading Techniques

Forex Pivot Points

MACD Divergence,

ADR Indicator

Best Forex Indicator

The HNW Club

Q&A

Market Update

And, you can check me out here.

If you would like to help me start a forum and be a moderator, I would love to hear from you.  Just drop me a line using the Contact provision at the bottom of my site.

If you would like to be featured in my blog, I would love to share your success story – or even your trading experience.  Please send me a message using my Contact form at the bottom of this page.

I won’t live long enough to know it all, and I won’t live long enough to make all the mistakes myself.  So, hearing your story will be most helpful not only to me, but also for my other beloved readers.

Please share this post.  Sharing is caring.  Thank you!

I look forward to your articles, feedback, ideas, stories, and suggestions for my blog.  Please post these on my blog at the Contact link below.  

HAVE FUN and ENJOY LIFE!  Remember – FAMILY comes first!

Here’s To Your Success and Quality of Life,

prbain

Peter R. Bain
PS:  Don’t let them steal your dreams!
PPS:  I will help you achieve your dreams!

About Peter R. Bain

Picture of Peter R. Bain, founder of www.TradingSmarts.com – the go-to site for all things trading.

Peter R. Bain

I am a speaker, trader, writer, aviator, car nut, Harley enthusiast but, above all else, I am here for you at TradingSmarts, which I founded some 15 years ago.

TradingSmarts is your best friend when it comes to finding anything and everything to do with trading.  Through my blog you will always find guides, news, reviews, tutorials, and much, much more.

TradingSmarts is a ‘NO-BS, No-Holds-Barred, Take-No- Prisoners’ site for traders who want the straight-bill-of-goods on how to make a full-time income trading less than part-time. 

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Peter R. Bain

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