Leverage and Margin Requirements
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 the ones that are participating in foreign exchange. Central and commercial banks, big financial corporations, treasury departments, etc. are the ones more active and have access to the capital needed for transactions.
In order to grant access for the 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 being moved on buying on selling is not the one from a trading account, but the one multiplied with the leverage.
The leverage size vary 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 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 one $/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 super conservative.
What Margin Means
A trading account has a Balance that shows the funds deposited initially, an Equity tab that shows the actual value of the account at any moment of 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 one moment of 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. This way the margin blocked will be released and it can be used for opening a new trade.
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What Is a Margin Call?
A margin call is always something a trader wants to avoid and yet there is no trader that in his/her life didn’t receive it. The very idea of a trader receiving a margin call from the broker is a negative one as it implies a lot of things went bad in trading: the account was over traded (too many positions were opened), no money management techniques were used, and the capital invested is closed to be depleted. Such a margin call means there are no more funds in the trading account to be used for sustaining the currently open positions and the trader faces a tough choice: either to add new funds or the broker will automatically close the positions. 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 need 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 that offer the possibility of opening a trading account with a leverage more than 1:500 and sometimes even more than 1:1000. However, those are not reliable brokers that should be used when trading as they are targeting winnings only from commissions as trades are being closed really fast due to the large exposure in the trading account. A classical mistake that a trader is making is to look only 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 on as Equity, as this value is rising or falling according to how the trades show: a profit or a loss.
In other words, one may see the Balance showing the initial amount funded, for example, 5000 USD but still receiving a margin call. This is happening if all trades taken are still open and the market goes in the opposite direction. While the balance will be affected and will change only 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 bigger 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 mobilized for sustaining those positions. The more margin is blocked, the more exposed the trading account is to small fluctuations that can wipe out the entire capital in a 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 limitations and trading capabilities and adapt all the time in such a way that the account grows without receiving a margin call.
Other educational materials
- Forex Trading Platforms – Metatrader 4 and 5
- 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.