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FOREX Leverage, Margin and Margin Calls

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Unraveling the Mystery

by Patty Kubitzki

 

If the terms leverage, margin and margin call bring thoughts of uncertainty to mind, you are not alone. It’s no wonder there is such a lack of understanding of these terms and practical trading application of the principles behind them as the brokers barely touch on the meanings and give few examples. Yet, the lack of knowledge with proper application will inevitably be the Forex trader’s doom, resulting in overtrading and a broker margin call to close losing positions.

To understand how to be protected from a margin call, we have to first understand the terms involved. Then we will need to understand and calculate how much margin the broker requires in our account to sustain the open positions and the maximum our positions could possibly draw down or move in the negative before closing at the investor’s stop loss or creating a broker generated margin call.

The leverage available in Forex trading is one of main attractions in trading this market.  Leveraged trading, or trading on margin, simply means that you are not required to put up the full value of the positions you trade.

There are several reasons for the higher leverage that is offered in the Forex market. On a daily basis, the volatility of the major currencies is less than 1%. This is much lower than an active stock, which can easily have a 5-10% move in a single day. With leverage, you can capture higher returns on a smaller market movement. More importantly, leverage allows traders to increase their buying power and utilize less capital to trade. Of course, increasing leverage increases risk.

Leverage, in essence, is a loan that is provided to an investor by the broker that is handling his or her Forex account. When an investor decides to invest in the Forex market, he or she must first open up a margin account with a broker. Usually, the amount of leverage provided is either 50:1, 100:1 or 200:1, depending on the broker and the size of the position the investor is trading. Standard trading is done on 100,000 units of currency, so for a trade of this size, the leverage provided is usually 50:1 or 100:1. Leverage of 200:1 is usually used for positions of 50,000 units or less.

Although the ability to earn significant profits by using leverage is substantial, leverage can also work against investors. For example, if the currency underlying one of your trades moves in the opposite direction of what you believed would happen, leverage will greatly amplify the potential losses.

Margin is the aggregate amount of customer cash pledged against the aggregate Open Positions. The margin pledged is a function of Maximum Trading Leverage Ratio. The higher the leverage, the lower the pledged Margin. The lower the leverage, the higher the Margin needed to carry the position.

Mathematically, Margin = Open Position Amount / Maximum Trading Leverage Ratio. For example, a USD/CHF 100,000 USD position (one standard lot) at Maximum Trading Leverage Ratio 50:1 will require pledged Margin equal to 100,000/50 or $2,000.

The Margin Used formula can also be stated as:

   Account unit / leverage X # open lots X exchange rate (use 1 if USD)

 

To assist with the calculations use Patty’s Forex Margin Calculator (examples shown below) which may be downloaded at no charge from www.SecretsFromTheHeart.com.

 

The TakeProfit amount needs to be 0 when calculating draw down. If you would like to know the maximum distance the currency index might move before closing at Take Profit, enter your Take Profit value as well as the Stop Loss and Spread values, then click Calculate. The number shown in Worst PiP Drawdown is a total of Grid Spacing or Stop Loss + Take Profit + Spread.

 

Account Balance can also be a lower number than the actual account balance. So if the investor wants to risk only a certain dollar amount of their account, say 50%, they would enter the lower dollar amount. Then, they would experiment with the Total Lots and or Stop Loss values to determine their limits.

 

When using the Margin Calculator to calculate the Worst Total Drawdown on a Grid type trading method, each lot level would have to be entered separately, then totaled manually, since the trades will likely not have the same pip drawdown. 

 

 

Note: To calculate margins for currency pairs, where USD is NOT the Base (First) Currency (e.g. EUR/USD, GBP/USD…) and crosses (EUR/JPY, GBP/JPY…), the Counter Currency amount is first converted into USD using the average exchange rates.

Example: Customer buys 1 lot of EUR/USD when the price is 1.4428 – 1.4430. The average exchange rate is 1.4429. Therefore, 100,000 EUR equals 144,290 USD (100,000 X 1.4429). $144,290 / 50 Leverage Ratio = $2,885.80 margin required.

Another way to calculate it is to calculate it as you would for a USD base pair, then take the result and multiply it times the Base exchange rate at the time the open order is placed. So a 100,000 USD position at Trading Leverage Ratio 50:1 will require pledged Margin equal to 100,000/50 X 1.4429 or $2,000 X 1.4429 = $2,885.80 margin required.

When calculating the margin required on a cross pair such as EUR/JPY, the EUR is the Base currency so you will use the EUR/USD exchange rates at the time the open position is placed.

The formula to calculate the margin required is as follows:  

(Account type unit / leverage amount) X # of open lots X exchange rate( use 1 if USD is the Base) = margin required (which will show as Margin Used on investor’s account).

Example: Customer has a 200:1 leverage mini account and buys 2 mini lots (0.2) of EUR/JPY when the price is 163.47 – 163.50. The EUR/USD rate at the time of order execution is 1.4646 - 1.4648. The average exchange rate of EUR/USD is 1.4647.

10,000 / 200 X 2  X 1.4647 = $146.47 margin required.

Margin Call is a demand for additional funds to be deposited in a margin account to meet margin requirements because of adverse exchange rate movements.

 In Forex, due to the fast moving market, brokers don’t issue this demand warning. If Account Equity  falls below the Margin Used or the Margin Level % hits 100% or less, the broker will close some or all of the open account positions.  Brokers vary on their rules on a Margin Call. Be sure you understand the rules for the broker you are using.

Some brokers don’t do margin calls on demo accounts! Be aware of this while testing. Also, if you are demo trading, be sure the leverage is set as the same as you will be trading in your live account to have more accurate results. Also, if the trader has both long and short open orders on the same pair, some brokers (Interbank FX is one of these) only count the total lots going one direction, whichever direction is greater. So 15 lots short + 7 lots long would equal only 15 lots on calculating margin, instead of 22.

The margin deposit requirement may also be stated as a percent, such as 1%. 1% on a Standard Account would be $1,000 per 100,000 units. 1,000 / 100,000= 1/100 or leverage at 100:1. Some brokers may show the leverage numbers reversed, such as 1:100.

With 200:1 leverage the trader is required to deposit .5% (half of 1%) or $500

                  (500/100,000 = 1/200 or 200:1 leverage);

with 500:1 leverage the trader is required to deposit .2% (one fifth of 1%) or $200;

with 50:1 leverage the trader is required to deposit 2%, $2,000;

with 5:1 leverage the trader is required to deposit 20%, $20,000.

 

Calculating the worst possible draw down:

Now we can move on to calculating the worst possible draw down, which would be shown on the investor’s account as floating Profit/Loss.

 

Patty’s Forex Margin Calculator does all this for you but here is how the calculation is performed:

 

First calculate the draw down risk per lot.

For this, add the stop loss value plus the spread distance to obtain the worst possible pip draw down.

Then multiply the worst pip per lot draw down times the pip value, which will be the dollar amount of risk per lot.

 

Now multiply the dollar amount of risk per lot times the number of lots we want to trade to arrive at worst total draw down value.

 

This final value subtracted from the account balance equals the account equity. 

See previous sample graphics.

 

 

 

 

    Equity must be greater than Margin Used

or

Margin Level % greater than 100% to prevent a Margin Call.

   

   Also note, the Account Balance needs to be greater than  

      the Margin Used + Worst Total Drawdown (not adding the

                      drawdown as a negative number) to prevent a Margin Call.

 

Account unit values:

Standard Account Unit = 100,000

Mini Account Unit = 10,000

Micro Account Unit = 1,000

 

Calculation Formulas:

Margin Used = Account unit / leverage X # open lots X exchange rate (use 1 if

     USD)

Equity = Margin Used + Free (Usable) Margin

Equity = Balance + floating P/L (use Worst Total Drawdown in calculating)

Balance on the MT4 terminal window displays the total account balance of closed

   positions which = Equity - floating P/L (or Worst Total Drawdown in calculating)

Margin Level %  = (Equity / Margin Used) X 100

Free Margin = Equity – Margin Used

Worst Pip Drawdown = StopLoss( or Grid Spacing) + Spread

$ Risk Per Lot = Worst Pip Drawdown X Pip Value Per Lot

Worst Total Drawdown = $ Risk Per Lot X Total Lots

Margin Required Per Lot = Account type unit / Leverage X Exchange Rate of

     Base (use 1.0 if USD)

Total Margin Used = Margin Required Per Lot X Totals Lots

 

It makes sense that the more lots we have open the more account margin we use so the drawdown must be less to stay within our limit. And the opposite is also true, if we open less lots, using less margin, the account can sustain a greater drawdown. If this is unclear, go back to the Margin Calculator and experiment with it some more as this is critical that you understand this principle.

   

Comparing Leverage Levels

Due to the way Paradise and Trumpeter increase lot sizes as they trade, it is more effective to use a higher leverage level to reduce the Margin Used and allow for more trades to be placed and greater drawdown limits. The recommended level is 200:1 or greater. Below are screen captures taken from my leverage video which can be seen in its entirety at: Secrets Leverage Video.  

 

 

 

 

 

 

!    Reminder: Adding the Total Margin Used + Worst Total Drawdown is equal

          to the account balance required to sustain the positions. 

 

 

 

This document, along with Patty’s Forex Margin Calculator may be downloaded

at no charge from www.SecretsFromTheHeart.com.                                     

Last revised 04/12/09.

This information is offered for educational purposes only, you are not being offered or given financial advice of any kind. This document, as well as the Forex Margin Calculator program, may be modified or withdrawn at any time and without notice. They are offered ‘as is’ without any warranties or guarantees and are to be used entirely to your own risk without recourse to the originator and distributor. They are not to be copied, sold, shared or posted in any way or place to be accessed by others without written consent of Patty Kubitzki. Please direct people to www.SecretsFromTheHeart.com to obtain a personal copy and direct inquires and abuse to admin at secretsfromtheheart dot com. It is recommended that each investor verify the information and formulas provided for accuracy, prior to live trading on a funded broker account. Use due diligence and never trade with money you can’t afford to lose.

Margin Calculator Program with above PDF available FREE in VIP Member Area.

 

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