Margin and Leverage

What is the purpose of Margin Trading?

A very extended and poor definition of leverage is that it's a tool that will help traders earn money fast and easy. And indeed, one of the most important advantages of the Forex market is given by the effect of leverage. Without leverage, it would be very difficult to accumulate capital, especially for small investors. But leverage can also be very harmful if not properly understood. This duality is what makes this concept difficult to grasp and explains partly why there are so many misconceptions about it.

Financial leverage, meaning a purchase on a margin, is the only way for small investors to participate in a market that was originally designed only for banks and financial institutions. Leverage is a necessary feature in the Forex market not only because of the magnitude of capital required to participate in it, but also because the major currencies fluctuate on average less than 2% per day.

In fact, the mechanism of leverage is what enables the existence of broker-dealers. They also have accounts in different banks which serve them as liquidity providers, thus acting as lenders of first resort for the broker-dealer's margin transactions. This means that the bank allows the broker-dealer to trade with larger amounts of capital and the broker-dealer, in turn, transfers this benefit to the user. The 

capital deposited in the bank guarantees limited risk, as does your deposit with the broker-dealer.

 

How does Margin Trading work?

A trader who purchases, let's say a USD/JPY standard lot, does not have to put down the full value of the trade (100,000 USD). But to gear up the trade size to the institutional level, the buyer is required to put down a deposit known as "margin". The minimum deposit capital varies from broker to broker.

That is why margin trading can be seen as trading with borrowed capital– it's basically a loan from the broker-dealer to the trader, but based on the trader’s deposited amount. Margin trading is what allows leverage.

When executing a new trade, a certain percentage of the deposit in the margin account will be frozen as the initial margin requirement for the new trade. The quantity of required margin per trade depends on the underlying currency pair, its current exchange rate and the trade size. Remember, the trade size always refers to the base currency. Once the trade is opened, the frozen initial margin requirement may not be used in trading until the trade is closed. The more trades are opened simultaneously the more margin is required until it eventually becomes a notable percentage of your account.

 

How is Margin expressed?

If you ask your broker-dealer what their margin requirement is for a standard lot (100.000 units) they will give you a relatively small amount, typically 1,000 units. When you trade with 5,000 in margin and you control 5 standard lots worth of 500,000, that’s a 100:1 leverage, because you only have to post one percent of the purchase price as collateral.

This means the trader has to have at least 5,000 (5,000 + spread to be more precise) in the margin account to trade 5 full-size lots.

The normal margin requirement is between 1% and 5% of the underlying value of the trade, that is a leverage between 100:1 and 20:1, although some broker-dealers provide extreme levels of 200:1 (0.5%) and more. Most dealers scale their margin requirements which allow smaller accounts to use higher leverages like 100:1, than bigger accounts which are allowed to use only 50:1, or even 10:1. The currency denomination for the leverage depends on the brokerage through which you execute your trade, but it is usually US Dollars.

 

How to calculate Used and Available Margin?

Brokers usually refer to the maximum leverage you can get from them.  Like 50:1 (US brokers) or 100:1 or 200:1.  As we have seen before, the maximum leverage is a result of the margin requirement.

The margin requirement is a percentage of the value of the trade, based on the base currency.

If 50:1 is the maximum leverage the margin requirement is 2%.

If 100:1 is the maximum leverage the margin requirement is 1%.

If 200:1 is the maximum leverage the margin requirement is 0.5%

In order to calculate the dollar value of margin required for any specific trade you need only the trade value (e.g. GBPUSD 100,000 and the maximum leverage or the margin requirement percentage.)

If you want to trade 100,000 GBPUSD at a US broker where the maximum leverage is 50:1, which means the margin requirement is 2%: Thus it is 100,000*0.02 = 2,000 units of GBPUSD.  If you have a USD-based account this 2,000 GBP must be converted to USD by multiplying the amount (2,000) with the GBPUSD exchange rate, say 1.6000.  You will need $2000*1.4600 = $2,920 in margin for the trade.

If you want to trade 30,000 EURUSD at a broker with a maximum leverage of 100:1, it means the margin requirement is 1%.  This it is 30,000*0.01 = 300 units of EURUSD.  If you have a USD account this 300 EUR must be converted to USD by multiplying the amount (300) with the EURUSD exchange rate, say 1.1300.  You will need $300*1.1300 = $339 in margin for the trade. This is the amount that will be frozen by opening the trade and deducted from the available margin.

 

How does a Margin Call arrive?

The short answer is: very fast. The reason is in the mechanics.

If you have opened a trade and the price changes, so does the margin requirement (remember, it is linked to the exchange rate).  In order to see this at work, let’s assume you have a $12,000 account and decide to short  200,000 GBPUSD at 1.4600 at a broker charging 1% margin (i.e. 1,000 units per 100,000 traded).

The margin required is 200,000 x 1% x 1.46 = $2,920.

Once you have opened the trade $2,920 is earmarked as “used margin”. In turn, your “free margin”, which you can still use, is $9,080 ($12,000 - $2,920).

Let’s say you are short, targeting lower levels but the price goes up against you from 1.4600 to 1.5000 (400 pips).

As the GBP value increases your margin requirement increases because it remains 1% of the total value. At GBPUSD 1.5000 your margin required for the 200,000 GBP trade is 200,000 x 1% x 1.5000 = $3,000.  But at 1.5000 you have also lost $20 per pip x 400 pips = $8,000.

This means your account status is as follows:

Balance $12,000

Equity ($12,000 - $8,000) = $4,000

Margin used = $2,920

Free margin = $1,080

This means that if the market moves another 50 pip against you, your free margin will be $0.00 and the broker can bring a margin call. Before you reach that point the broker can close your position fully or partially, because if the price moves further against you for every adverse pip movement you have $20 less in margin available at 1%.

In practice, different brokers treat this differently.  Some will immediately issue a margin call by closing the full position.  Others may close half of the position.  Yet others may allow the position to deteriorate to some predetermined level of margin, let’s say 20% of the required margin is left and then close the whole position.

Technically many brokers will not make the margin call at the first level but wait for closer to zero.  Specially if they have at some point decided there is no point if off-setting your position in the market and just take the “risk” that you will lose all the money! (This scenario will not be applicable in a true straight through processing scenario where the broker has no other strategy but to pass on all positions.)

 

What is Effective Leverage?

On one hand, traders can exploit the maximum leverage that the broker-dealer provides, which can range from 20:1 to 100:1 typically, but this doesn't mean that you will use all that leverage.

When asking what leverage you are using in your trading, you have to refer to the leveraged ratio which you are effectively using to enhance your trading strategy. This is the point many traders miss and yes, and a point that they can control, not the broker!

The effective leverage is of paramount importance. There isn’t leverage you can choose other than the real leverage you trade with. The broker determines the margin requirement which is a percentage margin required for the trade value. This determines the maximum leverage.  In other words, you can’t choose maximum leverage, it's the broker determines that with the set margin requirement at 1% or 5% or whatever.  

There is nothing wrong in accepting the very low margin requirement of 1% or 0.5% the broker offers which allow you much higher maximum leverage that what would be possible if you choose to ask for much higher margin requirement! But that doesn't mean you will use all that leverage power.

Some brokers allow you to make a choice of margin requirement.  However, there really is limited benefit in that, considering your effective / real leverage should, in any case, be well below the maximums.  There is no real benefit in making your margin requirement so high that your maximum leverage is low.  

The effective leverage you use is what determines your risk because the effective leverage is the ratio between the money you have (your account equity) and the value of trade.  The value of the trade determines the value of each pip.  If your effective leverage is too high like in the 200,000 GBPUSD example above every pip change rips a large amount out of your equity and adds the same amount to your margin required. 

The effective leverage is calculated by dividing the value of open positions by the available equity of the account. In other words, the effective or real leverage is the amount of capital you are really using compared to the amount in your account.

With a position worth of $20,000 (2 mini lots) and an account balance of $1,000, the real leverage is 20:1 (20.000/1.000 = 20). If this trade loses 50 pips, the account balance would go down by 10% ($2,00 multiplied by 50 pips = $100).

Should this loss materialize, the real risk would increase with the next trade - now a loss of $100 is 11% of the account. This also means that the effective leverage rises even if the position size is kept the same, because the new account balance is now lower. This is the typical dynamic of a losing spiral, when traders blow up their accounts - by trading the same trade size, they lose more with each trade. This is because the effective leverage increases each time.

 

Note: this article has been co-authored by Dirk Du Toit