Forex Leverage and Margin Trading Explanation and Examples
Margin required : It is the amount of money your Forex broker requires from you to open a position. It is expressed in percentages.
Equity : It is the total amount of capital you have in your account.
Used margin : amount of money in your account that has already been used up when buying a currency contract, this contract is the one that is displayed in the open positions. As a trader you cannot use this amount of money after opening a trade because you have already used it and it is not available to you.
In other words, because your broker has opened up a position for you using the capital you have borrowed, you must maintain this usable margin for you as a security to allow you to continue using this leverage he has given you.
Free margin : amount in your account that you can use to open new positions. This is the amount of money in your account that has not yet been leveraged because you have not yet opened a transaction with this money - this is also very important for you as a investor because it enables you to continue holding your open trades as will be explained below.
However, if you over use leverage, this free margin will drop below a certain percent at which your broker will have to close all your positions automatically, leaving you with a big loss. The broker at this point closes all your position because if your positions are left open they would lose the money you have borrowed from them.
This is why you should always make sure you have a lot of free margin. To do this never trade more than 5 percent of your forex account, in fact 2 percent is recommended.
Difference Between Leverage Set by the Broker and Used Leverage
If the set leverage is 100: 1, it means you can borrow up to 100 dollars for every dollar you have but you do not have to borrow all the 100 dollars for every dollar you have you can decide to borrow 50:1 or 20:1. In this case even though the option set 100:1 your used leverage will be the 50:1 or 20:1 that you have borrowed to make a transaction.
You have 1000 dollars (Equity)
Leverage Used = Amount used /Equity
1 Contract, $100,000 Lot
If you buy one standard lot which is equal to 100,000 dollars you will have used
0.5 Contract, $50,000 Mini Lot
If you buy one 0.5 lots which is equal to 50,000 dollars you will have used
0.2 Contract, $20,000 Mini Lot
If you buy one 0.2 lots which is equal to 20,000 dollars you will have used
0.2 Contract, $10,000 Mini Lot
If you buy one 0.1 lots which is equal to 10,000 dollars you will have used
In these three cases you can see that even though the set is 100:1
The used is 100:1, 50:1, 20:1 and 10:1 depending on the size of lots traded.
So Why not Just Choose 10:1 option as the Maximum Leverage? Because to keep within the proper risk management rules it is even recommended that investors use less than this?
This question may seem straight forward but it's not, because when you trade you use borrowed money known A.K.A. Leverage. When you borrow capital from anyone or a bank you must maintain a security or collateral to acquire a loan, even if the security is based on monthly deduction from your salary, the same thing with Forex Trading.
In forex trading the security is known as margin. This is the capital you deposit with your broker.
This is calculated in real time as you trade. To keep your borrowed money you must maintain what is known as the required capital (your deposit).
Now if Your Leverage is 100:1
When trading if you have $1,000 and use option 100:1 and buy 1 standard lot for $100,000 your margin on this transaction is the $1000 dollars in your account, this is the money that you will lose is your open transaction goes against you the other $99,000 that is borrowed, they will close the open transactions automatically once your $1,000 has been taken by the market.
But this is if your broker has set 0% Margin Requirement before closing your trades automatically.
For 20% requirement before closing your trades automatically, then your transactions will be closed once your balance gets to $200
For 50% requirement of this level before closing your trades automatically, then your transactions will be closed once your balance gets to $500
If they set 100% requirement of this level before closing your open positions automatically, then your trade will be closed once your balance gets to $1,000: Meaning the trade will close out as soon as you execute it because even if you pay 1 pip spread your account balance will get to $990 and the needed percentage is 100% i.e. 1,000 dollars, therefore your orders will immediately get closed.
Most brokers do not set 100% requirement, but there are those that set 100% are not suitable for you at all, choose those set 50% or 20% margin requirements, in fact, those that set at 20% are some of the best because the likely hood they close out your trade is reduced as shown in the examples above.
To know about this level which is calculated by your platform automatically - The MetaTrader 4 Platform will display this as "Margin Requirement", This will be displayed as a percentage the higher the percentage the less likely your trades are to get closed.
For Example if
If leverage is 100:1 and you transact 1 Mini Lot, equal to $10,000
$10,000 dollars(mini lot) divide by 100:1, your used capital is $100
= Capital Used * Percentage(100)
= $1,000/$100 * Percentage(100)
Margin Requirement = 1,000 %
Investor has 980% above the required amount
If leverage is 10:1 and you transact 1 Mini Lot, equal to $10,000
$10,000 dollars(mini lot) divide by 10:1, your used capital is $1000
= Capital Used * Percentage(100)
= $1,000/$1000 * Percentage(100)
Margin Requirement = 100 %
Investor has 80% above the required amount
Because when a trader has a higher leverage means that they have more percentage above what is required(A.K.A. More "Free Margin") their open transactions are less likely to get closed. This is the reason why investors will choose the option 100:1 for their account but according to their risk management rules, they will not trade above 5:1.
These Levels are Shown on The Software Screen Shot Below as an Example:
MetaTrader 4 Platform