The Forex Terms Leverage and Margin
The Forex market is the biggest financial market in the world, and brokers allow Forex traders to buy or sell currencies in order to speculate on the future direction of a currency pair. Brokers intermediate the retail traders, but retail traders are only a small fraction of those who participate in foreign exchange. Central and commercial banks, big financial corporations, treasury departments, etc., are the most active players, and have access to the capital needed for transactions.
In order to grant access for retail traders to the Forex market, trading accounts are leveraged at the broker’s end. Depending on the size of the leverage, the actual amount of money that is moved on buying or selling is not the amount from a trading account, but that amount multiplied by the leverage.
The size of the leverage varies from broker to broker, and as a rule of thumb the bigger the leverage, the bigger the risk, so a trader may want to take this into consideration. If the leverage is too big, then even small moves the market makes are enough to wipe out the trading capital in an account. A classical leverage size is anywhere between 1:100 and 1:400. This means that for every 1 Dollar/Euro/Pound (or whatever the account’s currency is) in the trading account, the trader can move 100 times more in the case of a 1:100 account and 400 times more in the case of a 1:400 account. Any leverage bigger than 1:400 is considered to be too risky, while below 1:100 an account is seen as super-conservative.
What Margin Means
A trading account has a Balance tab that shows the funds initially deposited, an Equity tab that shows the actual value of the account at any moment in time, and a Margin tab. When a new trade is opened, a margin is blocked, and the size of this margin is directly linked to the volume of the trade. If one is trading 10 lots, the margin requirements for that trade are bigger than the ones needed for trading 1 lot. If the trader opens too many trades at any one moment in time, he/she will be limited in opening new ones, as there will be no margin left in the trading account. The only way to continue trading is either to close some of the trades that are open, or to wait for a trade to close automatically when the stop loss or take profit is reached. In this way the blocked margin will be released, and it can be used for opening a new trade.
What Is a Margin Call?
A margin call is something a trader always wants to avoid, and yet there is no trader who in his/her life hasn’t received at least one. The very idea of a trader receiving a margin call from the broker is a negative one, as it implies that a lot of things have gone bad in trading: The account was overtraded (too many positions were opened); no money management techniques were used; or the capital invested was close to being depleted. Such a margin call means that there are no more funds in the trading account to be used for sustaining the currently open positions, and so the trader faces a tough choice: to add new funds, or to have the positions automatically closed by the broker.
Leveraged products are risky products, and trading on leverage is a risky business. This is why on every Forex broker’s account you’ll see a risk disclaimer that points out what leveraged products are. Without leverage, Forex trading cannot be done, as it would require a lot of funds in the trading account. Because retail online trading is associated with small trading accounts, and retail traders are rarely trading for a living, this means that they are funding the trading account with small amounts, and trading would not be possible without the account being leveraged. There are Forex brokers who offer the possibility of opening a trading account with a leverage of more than 1:500, and sometimes even more than 1:1,000. However, these are not reliable brokers who should be used for trading, as they target winnings only from commissions, as trades are closed really fast due to the large exposure in the trading account.
A classical mistake that a trader makes is to only look at the balance amount in a trading account. This is wrong because that information is misleading. In reality, the value of a trading account is always shown by the funds available as equity, as this value is rising or falling according to whether the trades show a profit or a loss. In other words, one may see the balance showing the initial amount funded – for example, 5,000 USD – but still receive a margin call. This happens if all trades taken are still open and the market goes in the opposite direction. While the balance will be affected and will only change if a trade is closed, the equity will continue to shrink with each and every pip that goes against the open positions, and eventually the trader will receive a margin call.
Growing a trading account, in fact, means managing risk, and the biggest risk of them all is to overtrade. Overtrading means opening too many positions at the same time and in the same general direction, and this leads to more margin being mobilised for sustaining those positions. The more margin that is blocked, the more exposed the trading account is to small fluctuations that can wipe out the entire capital in the blink of an eye. Money management strategies and techniques call for no new trades to be taken if more than 20%–30% of the margin is blocked, and to always have a stop loss for the opened trades. However, making a money management plan and respecting it are two different things, as traders fail at the second part lamentably.
The way to successfully trade in a leveraged environment like Forex trading is to know yourself, with both your limitations and your trading capabilities, and to constantly adapt in such a way that the account grows without your receiving a margin call.
Other educational materials
- What is a Margin Call?
- Setting Up a Chart in Metatrader 4
- Forex Trading Accounts and the Value of a Pip
- The Importance of Swap and Spreads
- How to Enter/Exit a Trade
Recommended further readings
- “Leverage and Market Stability: The Role of Margin Rules and Price Limits” Chowdhry, B., & Nanda, V. (1998). The Journal of Business, 71(2), 179-210.
- “Leverage aversion and risk parity” Asness, Clifford S., Andrea Frazzini, and Lasse H. Pedersen. Financial Analysts Journal 68, no. 1 (2012): 47-59.