Leverage and margin explained

Leverage and margin concepts lay at the basis of the Forex market. With leverage you’re able to invest more money than allowed by your trading account. Therefore, you have more substantial amounts at your disposal. Margin stands for funds your account must have on the board to cover possible losses.

To be successfull on investing and trading on forex market, it is necessary to be clear about hiw leverage and margin work

Leverage

Even if exchange rates does not vary too much and too fast, losses and profits at Forex are usually higher in comparison to stock markets. The 100:1 leverage is set by almost all brokers, so you can sell or buy €100,000 even if you have only €1,000 on your trading account. Although you can find Forex brokers that offer more favorable terms, for example, the leverage as big as 400:1. As for Forex trading, leverage may not play on your side, but against you. For example, if you expected the currency rate direction, bit it goes to the opposite one, leverage can increase losses rather seriously.

Leverage and risks

Always remember that ven as small as one percent  jump may cost you all the money, depending on the amount of leverage that broker offers you. In order not to lose an impressive amount too quick, you should use small leverages.

For example, you have $10,000 account (i.e. margin), and you decided to use $2,500 for the trade with a leverage of 1:400. You can buy ten standard lots or $1,000,000. In case you made a mistake and market is 100 points against you, the loss per dollar is only 1 cent, but in this particular case it costs you $10,000.

First of all, you need to focus not on the leverage, but on money management and compliance with risks

Margin

When broker makes a “margin call”, your transaction is forced to clos. Your $10,000 is taken to cover losses incurred due to leverage and your deposit comes to zero.

 What’s the chance? To be true, 50 to 50. For a “margin call” the drop of the exchange rate or a temporary surge is quite enough to finish you profitable and smooth trade completely.

Calculating the margin level

The formula for calculating the margin level is as follows:

Minimum deposit balance (minimum margin) = (current position value – borrowed funds) / current position value

where

  • The current value of the position = Number of shares * Market price of the shares
  • Borrowed funds = the broker’s credit money used by the investor

For example, an investor bought 1,000 shares of XXX at a price of $50 dollars a piece. The initial margin set by the exchange is 60%.

Current position value = 1 000 * $50 = $50 000

Borrowed funds = (1 000 * $50)*(100% – 60%) = $20 000

Let the minimum margin is 25%. This means that the buyer must maintain a net value of 25% of the total value of all securities. That is 25% * $50 000 = $12 500.

Question: at what shares price will investor get a margin call?

Let’s make a calculation

(Current position value-Borrowed funds) / current position value = 25%

(1,000*Price – $20,000)/ 1,000*Price=0.25

(1,000*Price – $20,000)=250*Price 750*Price=$20,000

Somewhere instead of the “margin call” term you can find “fed call” or “maintenance call” terms.

How to avoid such losses?

Try not to use large leverage, let it be moderate. Some Forex brokers limit it to 1:50. This is quite normal, many experts agree that this is the maximum allowed size that You can use without risk to your account.

If you decide to use a large leverage, keep in mind – it’s just like a Russian roulette. Don’t use more than 5% of the margin making a trade. Depending on the rules of risk management and what strategy you use, this figure may change, but don’t let it exceed 25%. Otherwise you weaken the overall account leverage. Stop loss for large leverage. Choose your own level, – flexible enough for leverage trading and rather secure for your account. If you plan and control trading, then leverage can help you increase your income. However, always adhere to the principle – using leverage or not, you should make your trading profitable.

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