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Forex Essentials Course: 21 lessons to get started in Forex

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7. Margin and Leverage

Tue, Oct 21 2008, 12:40 GMT
by PFX Team

LearningMarkets.com

Understanding risk in the forex

When you buy a currency, it's different than buying a stock. When you buy shares of a stock, the maximum amount you can lose is the face value of your investment. You buy 100 shares of a stock at $10 per share, and your maximum loss is capped at $1,000.

When you buy a currency contract, you are speculating on the value of one currency compared to another. The risk is therefore unlimited, as theoretically, the value of a currency can fall against another infinitely.

In this course you'll learn to control that risk, and set "stops" to automatically exit a trade and avoid more loss than you're willing to absorb. But understand that the forex has nuances related to risk that are easily overlooked, and can be devastating to you as a trader if you don't take the time to learn them properly.

This lesson will discuss those nuances: Leverage and Margin.

Margin and Leverage are widely misunderstood - Many traders fail to learn this and "blow up" their accounts

I find that there are a lot of traders who do not understand these concepts. I think this misunderstanding stems from the fact that it can be a little tricky, and almost all dealers are very misleading about the purpose and use of leverage in their advertising.

Margin and leverage are related issues that you will deal with in the forex, however, they are not the same thing. Misuse of margin and leverage is probably the most common theme in traders who lose all their money.

To compound the issue, most forex dealers use advertising tactics that are deceptive about their most extreme levels of margin or leverage, and what can actually be considered usable margin and leverage. Institutional investors know the difference and -- so should you.

Fortunately these concepts aren’t difficult to understand and will help you in a later section on position sizing.

Margin: When enter a forex contract you are not actually buying all that currency and depositing it into your account. You are contracting with your dealer that they will pay you, or you will pay them, if the value of the currency pair moves up or down.

However, you will gain or lose profits as though that money was in your account. If you make money on that trade, the gains will add to your account balance. If you lose money on the trade, money will come out of your account. To protect themselves, dealers require margin.

Margin is like a good faith deposit, made by you, to your dealer or broker, against potential losses. It means that your dealer is going to freeze a small amount of money in your account per lot that you are trading. That money may not be used in trading until you sell that contract. If your losses drain your account to less than that margin amount, they will close your position and leave you with whatever is left in the account. Forex traders call this “blowing up” their account.

This way - the dealer can be sure there is enough money available in your account to cover losses (which we discussed are theoretically infinite). The margin or deposit amount for one lot is usually only a small part of your account, but if you have many positions open the total margin may become a notable percentage of your account.

Many dealers have a margin requirement of $1,000 per full currency lot. Assume your dealer does, and your account has a balance of $10,000. Investing in one currency lot will leave you $9,000 available for other investments. The $1,000 of margin is not taken out of your account, but it is also not available for you to use until the position is exited.

This is where it gets a little tricky. If you ask your broker what their margin requirement is for a full size forex lot they will give you a relatively small amount, typically $1,000.

However, let's say you have an account with $10,000 and just one open position (trade). They won’t automatically close your trade if your losses exceed $1,000. They will close your account when your net balance (account deposits – losses) is less than $1,000.

So if you left a bad position on and it accumulated $9,001 worth of losses, your position will be closed by the broker and you will be left with $999 on deposit.

So margin, therefore, is the minimum net amount you must have in your account to cover losses on your current positions. This is why futures accounts are often called “margin accounts.” Fall below the minimum margin account level and you will have your positions closed for you. That is not a fun experience and a good trader NEVER lets it happen.

Leverage: Leverage is related to margin. In fact, it is a function of the minimum margin amount your dealer requires. As the term suggests, leverage is using a small amount of capital to control or move a much larger amount of capital. Dealers will advertise leverage in ratios like 100:1, 50:1, or even 400:1!

Here's what that means. If your dealer's margin requirement is $1,000, and one full lot of the USD/JPY gives you $100,000 of notional value, then your dealer is offering you 100:1 leverage. Leverage rates vary and we have included a few tips to optimize benefits of leverage in the video below.

Now, don’t be fooled! Dealers will want you to trade the highest leverage rates available, because it increases the amount of lots you can/will trade. This is dangerous to you as a trader. It's like having a credit card where, once you've maxed it out, the bank comes to you and tells you they've increased the credit limit so you can buy more stuff. The point is, you don't have to spend it just becuase it's there.

Imagine that you had a $10,000 account and you were using as much margin as you had available to control 10 lots of USD/JPY. That means you would be using a $10,000 account to control $1,000,000 worth of notional value or 100:1 leverage. What happens if the market moves 10 pips against you? What happens if you only used account leverage of 50:1? How about 10:1? The table below should help illustrate the point.

Of course, what we learn from this example is that it doesn’t matter what your maximum leverage is. In fact, that is little more than a sales gimmick. Your actual leverage is a function of how you size your positions and how much capital you are willing to tie up in margin.

The bottom line is that margin and leverage is something that you have more control over than you may have thought. As you use more leverage, your account will become more volatile and the risk of account killing losses increases. Don’t be fooled by sales gimmicks, look for real value. In many cases, good dealers will even offer you much more favorable roll over rates if you voluntarily limit your maximum leverage to 50:1.

Forex Essentials Course - 21 lessons:

Published on  Tue, Nov 18 2008, 17:26 GMT