When trading Forex, traders have the use of leverage. Leverage can be a really dangerous tool for traders if they don’t understand it and don’t use correct position sizing. For the trader who is well educated leverage can provide a very powerful tool to build profits.
Leverage works by letting traders enter into trades with only a fraction of the money down. In straight stock trading, traders have to pay for every dollar they invest. For example; if a trader buys $5,000 worth of stock XYZ, they would then have to front up the whole $5,000 to buy those shares.
In Forex traders can use leverage to enter trades whilst only paying a small amount up front. The most common leverage amount is 100:1. This means that for every $100 traded, the trader only needs to front up $1 to enter that trade.
Recently in the US the government has brought in stricter rules with leverage in trading which states US brokers can only allow clients a maximum of 50:1 leverage. In other countries outside of the US leverage ranges from 50:1 right up to 1000:1. If leverage is used as a professional tool 50:1 or 100:1 is more than enough to trade successfully.
Another example of using leverage would be; if trader Joe was going to place a $100,000 with 100:1 leverage, Joe would only need to put up $1 for every $100 of the $100,000 trade. How this would work out in the brokerage account is that whilst the trade is open, the broker takes and holds the margin or the $1 for every $100 until the trade is closed.
Once the trade is closed the broker gives back the money that was held and used as margin. In this scenario Joe would have to front up $1,000 margin to place the trade because that is $1 for every $100 of the $100,000 trade placed.
The reason that leverage can be a huge problem for the uneducated trader or gambler is because it allows them to enter huge trades with only a small outlay. Trading this way will increase the risks massively and lead to potentially wiping out their account.
If leverage is used in a more professional manner it can be used as a tool to manage risk and increase profits. I discuss how traders can use leverage like a professional and with the correct money management in this trade lesson; Using the Correct Money Management
Margin
Margin goes hand in hand with leverage. Margin is the amount your broker asks you to place up front for any trades you are in. The amount of margin required by the broker will depend on both the size of the trade and how much leverage is being used.
If you are using 100:1 leverage the broker will require $1 dollar for every $100 you have in an open trade. If you are in a trade that is worth 10,000 you will be required to put up $100. The bigger the trade size the more the broker will require. The smaller the leverage the more the broker will require.
Margin is not money that the broker holds onto. When you close out your trade you will get your margin back, the broker just holds it as security for your trade. Whilst this margin is being held, you cannot use it to place other trades. If you have a $5,000 account and with trades on have margin required of $2,500 you can only place trades using the last $2,500.
How to Calculate Forex Margin Requirements?
In order to calculate the margin requirements for any open trade or trade position that you have on your account the following general formula is used:
Example: Let’s assume you want to buy 2 standard lots of EUR/USD at a currency exchange rate of 1.1500, using 1:100 leverage with an account denominated in US dollars. We will get down to putting these values into our margin requirement formula as follow:
– Contract size = 100,000 (Standard Lot = 100,000);
– Lot size = 2;
– Account Leverage = 1:100;
– Open Price = 1.1500;
Margin requirement = (100,000 * 2 * 1.1500)/100 = $2300
So, in order to be able to make that trade, you’ll need to have in your account at least $2300, which means that your account balance needs to be at least $2300 otherwise the trade will be rejected due to insufficient margin available.
Margin Calls
Margin calls are something that a lot of traders are very scared of. This should not be the case and if traders are trading sensibly and not like gamblers they do not have to fear margin calls. Please read the above lesson on money management for how you can avoid margin calls.
A margin call is when your account is getting low and getting to the point where you will not have enough money to meet the margin requirement of your broker. Margin calls can come when you make a trade that is too big for your account size and the trade begins losing. If this losing trade starts to get close to the point where you don’t have enough in your account to meet the required margin, the broker will contact you. At this point you will be asked to either close out the trade or add more funds to meet the margin requirements. If you fail to do either of these the broker will close your trades.
Lots
When trading Forex traders enter what is called a “lot”. A lot simply refers to how much of a currency a trader is trading. Instead of buying massive amounts of an individual currency pair a trader enters the amount of lots that is suitable. There are 3 main lot amounts which are:
- Standard Lot – 100,000
- Mini Lot – 10,000
- Micro Lot – 1,000
An example of entering a trade using lots would be as follows; Trader Joe wants to enter a trade buying 60,000 EURUSD. To do this Joe will enter 6x Mini lots.
Pips
A pip is the smallest increment a currency pair can move. Each currency pair is normally quoted in either 4 or 5 decimals and in the case of some Japanese Yen pairs they are normally quoted in either 2 or 3 decimals. The pip is quoted on the 4th decimal or 2nd decimal(for some Yen pairs). When trading we use the amount of pips to work out things like our entry, stops and targets as well as things like the profit made and amount of risk.
The picture below shows an order window. The 4th decimal or the 2nd decimal is known as a Pip with the 5th decimal known as 1/10th of a pip and they are also called “pipettes.”
For example if the EUR/USD exchange rate moves from 1.1500 to 1.1501, that 0.0001 move represents a one pip change in price.
How to Calculate Pip Value
The pip value will allow us to translate “pips” into dollars and it will help us understand how a certain number of pips means a certain amount of profit or loss in our account and ultimately it will help us to understand Forex risk better. Besides the “pip” variable we also have a specific volume of our transaction which is represented by the number of Lots variable, and together these two variables combined will determine the Pip Value for our transaction.
The Pip Value is not just a function of the currency pair you trade as Pip Value depends on the number of pips the currency pair has moved and also on the volume of your transaction. If you enter into a trade with a higher number of lots than your pip value will be higher and if you enter a lower number of lots than your pip value will be lower.
It’s important to understand how to calculate the pip value in order to know how much money you’re going to make or lose. Each currency has its own relative value and the pip value will depend on that.
Whatever currency the account is, when that currency is listed second in a pair the pip values are fixed.
If you have a USD base account, any pair that is xxx/USD, such as the EUR/USD will have a fixed pip value.
A standard lot will then be worth USD $10, a mini lot USD$1, and a micro lot USD$0.10.
This method also applies if your base currency is different.
If the US dollar is the base currency (E.g. USD/CAD) we’re dealing with a direct rate and the Pip Value can be calculated by using the following formula:
Pip Value = (One Pip / Exchange Rate) * Lot size
Example 1: If we buy 1 standard lot USD/CAD at an exchange rate of 1.3500, each pip move in your favor will be worth 7.4 USD.
Pip Value = (0.0001 / 1.3500) * 100.000 = 7.4 USD
If your account currency is USD and we want to know the pip value of the EUR/CAD, the standard lot for the CAD is 10 CAD$ for this pair. We need to convert that 10 CAD$ to USD by dividing it by the USD/CAD rate. If the rate is 1.3500, the standard lot pip value is USD $7.40
So, for every 1 pip move in EUR/CAD, you’ll earn 7.40 USD if the exchange rate moves in your favor our lose 7.40 USD if the exchange rate moves against you.
To find the value of a pip when the USD is listed first, divide the fixed pip rate by the exchange rate. For example, to find the value of a standard lot, if the USD/CHF exchange rate is 0.9920, a pip is worth USD $10.08.
Other Lessons On Forex Money Management
– Forex Money Management That Actually Works and How to Use it!
– Working Out All Forex Positions in Money and NOT Pips!
