One of the key elements a trader needs to understand when trading Forex is the relationship between leverage, margin and margin calls. Many novice traders lose money sometimes because they don’t understand the downside or the benefit each can offer.
When trading Forex using a portion of your capital, the movements in the currency pairs’ prices are so small they would result only in minimal gains and losses, which makes it almost pointless.
In the past it was only big institutions like banks and investment houses that had the money to make trading worthwhile, but since the advent of leverage, normal traders can trade like banks if they wish.
To do this, Forex brokers effectively provide a leverage, which is a multiple on the amount the trader decides to trade with from his capital. It’s not a monetary transaction so there is no interest on the borrowing; the Forex broker simply provide these multiples in exchange for the spread, which is practically the broker’s return for the risk of holding the position. The amount of leverage the broker provides depends on the financial credit offered to the broker by liquidity providers. Leverage ratios are higher outside the US as US regulatory authorities were concerned over reckless trading and therefore limited leverage to a maximum of 1:50 whereas outside of the US, leverage ratios can reach 1:1000. Usually the leverage falls between 1:100 – 1:400. This means that a trader with a capital of $10,000 could effectively place a trade of $4 million assuming a leverage ratio of 1:400.
To clarify, if a trader is working with 1:400 leverage ratio, then a trade with $10,000 achieved 1% increase in the price of a currency pair would lead to $40,000 profit, which is an effective gain of 400% on his capital. However, using the same capital but with a leverage ratio of 1:1, the profit of the 1% increase would be $100.
The margin requirement is practically the same as leverage but by another name and form. The leverage ratio is the multiple the broker provides to make trading worthwhile for clients, whereas the margin requirement is the percentage of the amount the client has to provide in order to execute a specific trade. The amount of leverage a broker offers determines the margin requirement a client must maintain. Leverage is inversely proportional to margin, which can be calculated using the formula below
Margin percentage = 1 / Leverage
For example, 1:50 leverage is 1/50, which is a margin of 2%. A 1:200 leverage ratio will results in 0.5% as margin percentage. The nominal value of the margin required can be calculated using the formula below
Margin = Margin percentage (Contract size × Рrice)
For example, a margin requirement of 0.5% on one lot of EUR/USD, which is 100,000 Euro, at a price of 1.1300 equals 565 USD.
Many emotional traders simply look at the potential upside of leverage when they should first consider the downside. In the example above, if that 1% rise was reversed into a 1% fall, then effectively the trader has lost four times his initial capital or, in other words, he would only have had to see a 0.25% fall to have wiped out his account. Obviously the sensible trader would trade less of an amount (smaller position) and would have set a stop loss to put a cap on his losses. Forex brokers also do the same and have stop loss orders, but it’s known as margin calls. When a trader execute a position in the currency market, the broker carries the risk by taking the same exact trade. So when there isn’t enough funds available in the client’s account to hold this trade for more time due to the floating loss incurred on the trading account, the Forex broker has to stop his loss, and notify the client of a margin call. A margin call is a notification the client receives when the margin’s nominal value of all open positions reach 100% of the money left in the account. The client would be forced either to deposit more money in the account or to close some of the losing positions.
Sometimes the broker do not have a margin call, only a stop out level, which is a percentage of the margin at which the broker is forced to close all positions to minimize the risk it is exposed to because of the client’s trading positions and lack of funds. The stop out level is a guarantee for the broker to make sure the client doesn’t loss more than his capital or available funds. Some brokers will telephone or send an SMS to their client informing them that their trade has reached a margin call, giving them the option to close the trade or add more funds to hold the position. Regulated brokers are required to clarify to the client the margin requirement, margin call level and leverage ratio when opening a Forex trading account.
Sensible traders use only a small proportion of their capital on each trade – often less than 5%. This way they can benefit from the leverage offered but also reduce losses and the likelihood of margin calls. It’s also recommended that you don’t seek out high leverage ratios if you are still a new trader.
One of conclusions a trader forms about Forex trading and on regulations after a few years of experience, that a lot of new or small traders lose money in Forex trading unfortunately because they didn’t understand what they were doing, and what does leverage, margin requirements margin call and stop out mean.