Understanding Margin and Leverage in the Forex Market

Understanding Margin and Leverage in the Forex Market

Margin and leverage are fundamental concepts that each beginning forex trader must comprehend to be effective.

What is leverage?

When you decided to purchase a home for the first time, chances are you didn’t have enough money to purchase the home at its listed price. Traditionally, you would place a down payment on a home of 25%, and borrow the rest of the money from the bank. Whether you knew it or not, but you were using leverage to purchase your house.

Leverage gives you access to massive sums of money with only a small initial deposit.

Leverages are shown as a ratio. For example, a 25:1 leverage will give you access to 25 times more money than you place in. In this example 00 dollars will grant you to purchase a standard lot, which is 0,000 worth of currency.

Different brokers will have different leverages. Typical leverages are 10:1, 20:1, 30:1, 40:1, 50:1, 75:1, and 100:1. If you are trading using 100:1 leverage, you would be able to purchase a 0,000 of currency for only 00. You are spending less of your own money to purchase that currency. Why wouldn’t you use the highest leverage available?

The easy fact is that the higher leverage you use, the higher risk there is. The make more money when you are right, but you lose more money when you are wrong. Don’t forget:

High leverage = High risk.

Example of Leverage

State you are bullish on the USD/CAD pair, and believe that the USD will become stronger compared to the package currency. In other words, you think the price will go up. At a price of 1.0662, you purchase a standard lot using 25:1 leverage, which means spent 00 to purchase 0,000 of USD currency.

It turns out that you were right, and you sold the currency pair at 1.0702, which was 40 pips above what you purchased it. You have profited approximately 0 USD from this trade from an initial investment of 00 dollars. This means your return on investment (ROI) is 10% (0 / 00) from this trade. Not bad for one day’s work.

But envision what would have happened if you purchased it using 100:1 leverage. You will only spend 00 to purchase 0,000 USD. The price still increased 40 pips, which equates to approximately 0 USD. You ROI is now 40% (0 / 00).

From this example you made four times as much with a higher leverage. But if the price decreased 40 pips, the results would be the exact opposite. Using a 25:1 leverage, you would have only lost 10% of your initial investment. But if you used 100:1 leverage, you would have lost 40% of the investment, which is nearly half of what you place in!

The amount of leverage you use will be determined by how well you handle risk. Some people are naturally more capable of handling risk than others. But when you first begin out, I highly advocate not using more than 25:1 margin.

What is Margin?

The margin is the amount of money as a percentage that you would have to place up to purchase a contract. Depending on your broker’s margin policy, if your statement equilibrise dips below the margin, you will get a margin call and all your open positions will be shut for you.

How to Compute Margin?

Leverage and margin are related by the following formula:

Leverage = 100 / Margin
Margin = 100 / Leverage

So 25:1 leverage would indicate 4 percent margin (100/25). Here are some other common ones:

100:1 Leverage = 1% Margin
50:1 Leverage = 2% Margin
40:1 Leverage = 2.5 % Margin
30:1 Leverage = 3.33 % Margin
25:1 Leverage = 4% Margin
20:1 Leverage = 5% Margin
10:1 Leverage = 10% Margin

I think you get the idea.

Example
In this next example, I am buying a mini-lot (,000). The margin used is calculated automatically for me on the picture below. In this example, we want to find out how the margin is calculated if our leverage is 50:1.

You are putting up 0 USD of your own money to purchase a ,000 mini contract. Therefore you are putting up 2% (200 / 10,000) of your own money. To compute the margin, we take 2% of ,000, which is 0.

How to Compute Margin 2

What happens when the base currency is not the same as the home currency? Each currency pair is listed with two numbers. For example, you will often see EUR / USD = 1.40917 / 1.40912. The first number is the base currency, and the second number is the quotes currency. The home currency is USD if your forex statement was deposited using US currency.  If this doesn’t make sense, click here to review the basics.

In this case, when you purchase or sell a standard lot, the currency of that lot will be in Euros, but the margin will still be listed in your home currency (USD in our example). How does the margin get calculated? Let’s take a look at another example.

We are buying a standard lot of the EUR/USD pair. Once again, the margin is automatically calculated for us. But how did we arrive at that number?

Let’s take a deeper look. Since the quoted price is 1.40792, this means that it costs 1.40792 USD to purchase 1 EUR. A standard lot of 100,000 EUR will cost 140,792 USD. I am glad that we have margin because I sure don’t have that kind of money!

We know from our broker what the leverage is (50:1 in this case), so we can compute the margin. A 50:1 leverage is the same as 2% margin. Two percent of 0,792 is 15.84, which is the margin listed. We now know how to compute the margin. The margin calculation uses the following formula:

Margin Used = ((Base Currency / Home Currency) * Units) / Margin Ratio

Base Currency / Home Currency = EUR/USD = 1.40792
Units = 100,000
Margin Ratio = 50

Margin Used = (1.40792 * 100,000) / 50 = 15.84

How to Compute Margin 3

We will go one step further determine how the margin is calculated if both the base currency and quote currency are different than the home currency.

The home currency is still USD, but now we want to purchase 100,000 units of the EUR / GBP pair.

We will use the formula from above to compute the margin.

Base Currency = EUR
Home Currency = USD
Base / Home Currency = EUR / USD = 1.40884
Units = 100,000
Leverage = 20:1

Margin Used = (1.40884 * 100,000) / 20 = ,817.68 USD.

Summary

The ideal mortal to tell you what type of leverage to use is you. Only you will know what type of risk tolerance you have. However, I highly advocate not using too much leverage if you are just learning how to trade. Most professionals don’t use more than 50:1 margin, and neither should you.

You should also know how to compute the margin so you can plan ahead and know how much of your money is actually being risked, and refrain the nasty margin call.

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