I have had a number of subscribers email me asking what the difference is between margin and leverage. Some of you have even asked why I don’t use more leverage for greater returns in my Forex signals trading. I will address these three issues separately and then discuss their relationship to each other.
Forex Margin:
I’ll deal with margin first. Forex margin is simply the collateral needed to cover the credit risk of a trader to a broker. Basically, it is how much money that is required to make a trade. For example, if your retail Forex broker offers 50:1 leverage, then the margin requirement to make the trade is 2%. In other words, you would need $2,000 in your trading account for every $100,000 standard contract traded. So the formula is: margin = 100 / leverage.
Leverage Forex:
Next, I’ll discuss leverage. If you haven’t already noticed from the previous paragraph, leverage and margin work inversely with each other. Leverage is just a function of available margin which value is determine by account balance and value of open positions. Leverage Forex can be calculated by dividing the margin into the total current value of all open positions.
Simple, you would think so… but I would wager that less than 10% of the people trading the Forex understand this concept and the significance of it. This one factor is the reason why so many people “blow out” their trading accounts within the first six months of trading. Let me show you an example.
Let’s say that you want to go long EUR/USD and that the current price is 1.3200. Let’s also suppose that you have $10,000 in your trading account and that you only risk 2% per trade as per your trading strategy. Your Forex brokers offers 50:1 leverage and on this particular trade you have decided to place your stop loss at 50 pips away from your entry. Now, let’s calculate your risk for this scenario: Position size = $10,000 x (2/50) / 50 / 20 = 0.40 lots.
The margin requirement for XXX/USD is given by the formula: #lots x 100,000 / leverage x exchange rate. The margin you would need then is 0.40 lots x 100,000 / 50 x 1.32 = $1056, which is 10.56% of your $10,000 account. That leaves 100 – 10.56 = 89.44% of your account, or $8,944, for other trades. As you can see, trading at 2% risk leaves plenty of available margin (trading capital) in your account. Therefore, based on this scenario, leverage is not a major consideration for this trade. Also to note, is that the risk is always $200 no matter what the leverage is.
Forex Strategies:
Now I will deal with the question as to why I don’t use more of my available margin to increase my leverage and make a greater profit on my Forex trades.
To begin with, as is the case with most new traders to this market, I “blew out” three trading accounts when I first started trading Forex years ago because I didn’t understand this concept fully… the concept of margin and leverage. Yes, I learned the hard way; leverage will destroy your account very quickly if you don’t understand its power.
In addition, I do not use stop losses in my Forex strategies except to protect profits. There are a number of reasons I don’t use stop losses but I will save that discussion for another time. Suffice it to say, I need that extra margin for cost averaging in case my trades get too far out of whack (review my Forex trading performance).
In closing, I trust these Forex signals tips have driven home the importance of understanding how margin and leverage work together and how they can affect your trading account balance. Leverage is a two-edged sword so use its powers wisely. I hope that you have gleaned from the examples above that risking more that 2 – 3% of your trading account, on any one trade, will eventually knock you out of the game. If you will discipline yourself to stay at these levels, you will most assuredly live to trade another day.
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