Leverage and Margin Explanation & Example

Margin required : It is sum of money your broker requires from you to open a position. It is expressed in percentages.

Equity : It is 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 contract, this contract is one that is portrayed in open trades. As a trader you can not use this sum of money after opening a trade transaction because you have already used it and it is not available to you.

In other words, because your broker has opened up a trade position for you using the capital you have borrowed, you must preserve this usable margin for your account as a collateral to allow you to continue using this leverage he has given you.

Free margin : amount in your account which you can use to open new positions. This is amount of money in your account which hasn't yet been leveraged because you've not yet opened a transaction with this money - this money also is very important for you as a trader because it enables you to continue holding your open positions as will be explained below.

However, if you over use leverage, this free margin will go below a certain percentage at which your broker will have to close out all of your transactions automatically, leaving you with a large loss. The broker at this point closes out all your open trade position because if your open positions are left open they would lose the money that you've borrowed from them.

This is why you should always make sure you have a lot of free margin. ToIn-order-to do this as a trader never trade more than 5 percent of your account, in fact 2 percentage is recommended.

Difference Between Leverage Set by the Broker & Used Leverage

If the set leverage ratio is 100 : 1, it means that you can borrow upto $100 dollars for every dollar that you have in your account but you do not have to borrow all the 100 dollars for every dollar you have, but you can decide to borrow 50:1 or 20:1. In this case even though the leverage option set 100:1 your used leverage will be the 50:1 or 20:1 that you have borrowed to make a trade position.

Example:

You have $1000 dollars (Equity)

Set 100:1

Leverage Used = Amount used /Equity

If you buy lots equal to $100,000 dollars you'll have used

= 100,000/1000

= 100:1

If you buy trading lots equal to 50,000 dollars you'll have used

= 50,000/1000

= 50:1

If you buy trading lots equal to 20,000 dollars you'll have used

= 20,000/1000

= 20:1

In these 3 cases you can see that allthough the set is 100:1

The used is 100:1, 50:1, 20:1 depending on the size of lots traded.

So Why not Just Select 10:1 option as the Maximum Leverage? Because to keep within proper risk management rules it is even adviced that traders 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 preserve a security or collateral to get a loan, even if the security is based on monthly deduction from your salary, the same thing with Stocks.

In the security is known as margin. This is 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 required capital (your deposit).

Now if Your Leverage is 100:1

When trading if you have $1,000 and use leverage option 100:1 & buy 1 standard lot for $100,000 your margin on this transaction is $1000 dollars in your account, this is money that you'll lose if your open trade transaction goes against you the other $99,000 that is borrowed, they will stop out the open positions automatically once your $1,000 has been taken by the market.

But this is if your broker has set 0 percent Margin Requirement before closing out your trades automatically.

For 20% requisite before stopping out your positions automatically, then your trades will be closed once your balance gets to $200

For 50 percent requisite of this level before stopping out your positions automatically, then your trades will be closed out once your balance gets to $500

If they set 100% requirement of this level before closing out your open positions automatically, then your trade position will be stopped out 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 go to $990 & the needed percent is 100 percent i.e. 1,000 dollars, therefore your orders will immediately get stopped out.

Most brokers don't set 100% requisite, 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 brokers that set it at 20% are some of the best since due to the likely hood they stop out your trade transaction is reduced as displayed in the example above.

To know about this level which is calculated by your software automatically - The MT4 Platform will display this as "Stock Margin Requirement", This will be displayed as a percent the higher the percent the less likely your transactions are to get stopped out.

For Example if

Using 100:1

If leverage is 100:1 & you transact lots equivalent to $10,000

$10,000 divide by 100:1, your used trading capital is $100

Calculation:

= Capital Used * Percent(100)

= $1,000/$100 * Percent(100)

Stock Margin Requirement = 1,000 %

Investor has 980% above the required amount

Using 10:1

If leverage is 10:1 & you transact lots equivalent to $10,000

$10,000 dollars divide by 10:1, your used trading capital is $1000

Calculation:

= Capital Used * Percent(100)

= $1,000/$1000 * Percent(100)

Stock Margin Requirement = 100%

Investor has 80 Percent above the required amount

Because when one has a higher leverage means that they have more percent above what's required(A.K.A. More "Free Margin") their open transactions are less likely to get closed. This is reason why traders will choose the option 100:1 for their account but according to their risk management guidelines, they will not trade above 5:1 leverage ratio.

The Levels are Dislayed on the Software Image Below as an Example:

MT4 Software