Part I. A Bit More About Leverage

A Bit More About Leverage - Forex School
Commander in Pips: Today I would like to start talking about Leverage. Although previously we’ve said that leverage increases sensitivity to price action both during wins and during losses, still I want to discuss it with more detail.

Do you ever think about leverage? - Forex School
Do you ever think about leverage? Take a couple of moments to consider – for example, why professional traders never apply greater leverage than 1:40, but most commonly less that 1:20-1:10? Second, why do most futures contracts trade with 1:10-1:20 leverage, provided by the exchange? For instance, Gold margin is around 9000USD per contract, contract is 100 Oz or 1600USD/Oz*100 = 160,000 USD – the value of single contract. 160/9~1:17 leverage. The same is for currencies. Crude oil – 100 USD/barrel, contract is 1000 barrels and margin around 5000-6000 USD, so again - 1:20 leverage. And the last one, why do solid financial institutions, provided access to financial markets, not feel hurt from so-called “low leverage”? Why they do not feel discomfort and lack of competitiveness when they offer just 1:40 leverage or even less, while retail forex brokers could offer as much as 1:500 but still remain retail brokers.

Pipruit: Well, I have only single idea about it. First, large market-makers and brokers have large barriers to get access to their services. Hence, most of their clients are professionals, rather than individuals. Since most professionals agree with low leverage and do not turn to retail rivals with huge leverage, I could say only, that probably they do not need it.
Commander in Pips: Ok, let’s assume it. And why then do retail brokers offer 1:500 leverage?
Pipruit: Probably, because the public needs it – individuals demand it, that’s why retail brokers provide…​

Commander in Pips: Hm, curious – now try to combine both statements – the one for professionals with the one for the public. Do you see any contradiction here?

Pipruit: Individuals demand from brokers things that professionals are trying to avoid – particularly leverage grater than 1:10-1:20.
Commander in Pips: Well, as a conclusion I can say only – either professionals are stupid or you can’t have it both ways.

Pipruit: Right, but I tell you what – I will better trust professionals.
Commander in Pips: Do you? This is very surprising decision, but speaking seriously – you’re absolutely right. So it turns out that it looks like leverage is a double-edged sword, and somehow professionals try to avoid using it freely and too much. I tell you even more – 1:20 is a killing leverage for professionals. Almost never they use just initial margin on an account bucks to bucks. They always have a significant additional reserve, so their margin is rarely grater than 1:10. What does it mean? There is no doubt that professionals are wise, otherwise they couldn’t become a professional. So if you would survive on the market as long as they do, you have to follow them – also in terms of leverage.

Pipruit: So, sir, applying our conclusions to Forex, we come to result that we can trade 1 standard lot, only if we have account of $10,000?
Commander in Pips: Not quite, because as we’ve estimated in previous chapters this is more the question of money management system. Probably it’s better to treat it like since you don’t have 80-100K USD – it is probably better to open an account that will allow you to trade mini lots. If you have less than 10K – open an account that allows you to trade micro lots. It does not mean that if you have, say, 10,000 USD, you have to trade 0.1 lot every time. Depending on your rules and money management, you probably will trade 0.1-0.3 lots, but your account should allow to do it.

Pipruit: I see, and what to do, if I have just 2000-5000 USD?​

Commander in Pips: Well – it’s better to deal with a micro account, I suppose.

Pipruit: Right. So, we should not open an account with 25$ or standard account with just 5000 USD just because brokers allow traders to do that.
Commander in Pips: Absolutely. Anyway dealing with Forex trading you have to be absolutely aware of terms of leverage and margin. Many newbie traders were eliminated from this business not because they were bad traders or had bad trading systems, but because of a careless attitude or misunderstanding of leverage and margin. If you also have this misunderstanding – then you will lose all your money sooner rather than later.

Leverage and margin definition

Once we’ve specified it already, I would like to reinforce it, since this is extremely important. Please, go on.

 Me? All right. In the Ancient World Archimedes said that he could lift the Earth by leverage if you can give him a long enough lever and a fulcrum to place it on. So, it tells us that with just a small physical effort, leverage lets you move much greater objects. This is physical leverage. Since we are discussing money leverage, we have to replace word “physical effort” with “money”. Then it turns that we can control large amount of money with small one. For example 1:100 leverage allows us control 100 K USD with just 1000 USD. That’s why it is called 1:100. Or, with 5000 USD we can control the same 100K USD, if we have leverage 1:20.
Commander in Pips: And how does this usually happen, that you can control 100 K with just 1 K USD?

 Well this is a broker’s service. It demands you to provide 1K, while allows you to borrow the other 99K. So, let’s say we have 1:100 leverage and control 100,000 USD with just 1000 USD. If our assets will increase to 101 K and we earn 1000 USD more we will get 100% outstanding return on our capital, since money that we’ve provided for trading is just the same 1000 USD. Hence 1000 of profit/1000 of initial assets x 100% = 100% gain. If we have 1:1 leverage, or trade with our money only, and everything else is the same we will have just 1K/100 K x100% = 1%. But what is the other side of leverage? IF you assume reducing of your position instead of increasing with the same 1000 USD you will get -100% or total loss of all assets with 1:100 leverage, or just -1% loss if you use no leverage. That is the second edge of the leverage sword. The pity is that many traders don’t fathom the idea that this sword cuts equally well from one side to the other.
Commander in Pips: Very good. And what can you tell us about the margin?

Pipruit: Well margin is precisely an amount of money that is demanded by your broker that we’ve spoken of just above. So, if broker provides 1:100 leverage and we want to control 100 K, we have to provide 100,000/100 = 1000 USD. This is the margin. If we will provide less, then we will be able to control a smaller total value – other words, our maximum position value will be smaller. Brokers usually appoint minimum deposit value that could be used for trading and maximum leverage that could be provided. For example 500 USD and 1:500. This combination gives us minimum required margin 500 USD, while our total trading assets could be as large as 250 K.
Commander in Pips: And why do brokers’ need it? What is margin?

 Well, broker uses it in two ways. First, this is some kind of guarantee of fulfillment of our obligations with those participants who will be a counterparty to our trades. This is some kind of first call. Second, if there will be slippage on the market this deposit will act as a cushion for the broker and it will allow him to close position without a personal loss. In general a broker has an average position of his clients within each trading pair. The broker unites it into single pool and acts on the interbank market now with this larger position, while it continues separate accounting within the clients inside itself.
Commander in Pips: Can you somehow estimate leverage, based on margin provided?

 Yes, usually margin shows as percent range. You have to divide 100 on percent margin to get a leverage. For example, if margin is 5% then 100/5 = 20:1 leverage.
Commander in Pips: Correct! What types of margin do you know?

 Well in general, there are two types of margins – “Initial margin” and “Maintenance margin”. The first margin is demanded by the broker to initiate a position, while the second is the absolute minimum of margin – if it will be reached you should deposit additional funds and reestablish margin at an acceptable level. For example, if initial margin is 1000 USD and maintenance is 500 USD, then initially you can open lot with 1000 USD. If price will move against you, your maximum floating loss could be no more than 500 USD. As long as loss does not exceed 500 USD, you can hold your position.
Commander in Pips: And what will happen if it will exceed 500 USD?

 Well, this calls as “margin call” – lack of sufficient collateral for getting leverage, you have to add 500 USD or your position will be forcefully closed by the broker. Broker will return you the rest of your money.
Commander in Pips: And why broker needs this maintenance margin?

 That is what you’ve called a cushion. The point is when margin falls to crucial level – the broker’s risk to get unwelcome loses at its own expense becomes significantly higher. If your money will not be enough to fulfill your obligations with the counterparty – then the broker will have to do it anyway out of its own expenses. That’s why maintenance margin is some kind of insurance for a broker that it will not catch loss during solid slippage, for example.

Commander in Pips: Right you are. I just want to add some another terms with margins. Some software shows such terms as:

- Margin required – that is the same as initial margin;

- Total margin or account margin – total margin that you have at your disposal;

- Used margin – sum that was reserved as collateral for current open positions;

- Usable margin – this is difference between Total margin and used margin.

Not all of them are used simultaneously, but sometimes we can see some of these terms. For example, Metatrade 4 – well known software also shows “Margin level”. This stat changes over time and shows the ratio Account Equity/Used margin.

 Hm, this is something new. Could you give a bit more clarification with it? 

Commander in Pips: Ok, let’s pass through it.

First of all, let’s say that you’ve just opened account with some broker in EUR. Your initial deposit 5000 EUR and broker allows you to use as much as 100:1 margin. Then, right at the moment when your assets just were deposited on account you will see the following statement by software:

Action Account Balance Total Equity Flow Profit/Loss Used Margin 100:1 Usable Margin
- 5000 € 5000 € - € - € 5000 €

You’re just starting itching to start. Finally, you’ve found nice context to open with 1 lot of some pair. Then statement has changed:

Action Account Balance Total Equity Flow Profit/Loss Used Margin 100:1 Usable Margin
- 5000 € 5000 € - € - € 5000 €
+1 Lot
- 5000 € 5000 € - € 1000 € 4000 €

You can see, that broker has applied the level of margin that it has promised to you, and set aside as collateral 1000 EUR. So your usable margin has reduced to just 4000 EUR. At the same time, not too much time has passed, so you do not have any Flow Profit/Loss (also known as Floating Profit/Loss) on your position. Later you start to see, that the market is moving against you and statement has changed due to this reason:

Account Balance Total Equity Flow Profit/Loss Used Margin 100:1 Usable Margin
5000 € 4650 € 350 € 1000 € 3650 €

How this could happen?

Pipruit: Well, I suppose that:

Usable Margin = Total Equity – Used Margin or

Usable Margin = Account Balance + Flow Profit – Flow Loss – Used Margin

Usable Margin = Total Equity – Used Margin or

Usable Margin = Account Balance + Flow Profit – Flow Loss – Used Margin

Commander in Pips: You’re absolutely right. Also you’ve noted correctly that Total Equity to sum of Account Balance and Flow Profit or Loss. Flow profit or loss is a current result on positions that you hold open currently. Ok, let’s proceed with an example. Then, market has reversed and now it is moving in your favor:

Account Balance Total Equity Flow Profit/Loss Used Margin 100:1 Usable Margin
5000 € 5580 € 580 € 1000 € 4580 €

You see, that market is showing 0.382 retracement and decide to add another 0.5 lot:

Action Account Balance Total Equity Flow Profit/Loss Used Margin 100:1 Usable Margin
- 5000 € 5580 € 580 € 1000 € 4580 €
+0.5 Lot
- 5000 € 5580 € 580 € 1500 € 4080 €

 Oh, I see that used margin has increased and usable market has decreased correspondingly!
Commander in Pips: Right. Finally, let’s imagine two different scenarios – market has hit your take profit order and you earn 800 EUR:

Action Account Balance Total Equity Flow Profit/Loss Used Margin 100:1 Usable Margin
- 5000 € 5800 € 800 € 1500 € 4300 €
-1.5 Lot
- 5800 € 5800 € - € - € 5800 €

 Right, software has automatically closed position by order, flowing profit becomes real and has passed into my account balance. Simultaneously used margin becomes equal zero, since no positions are open currently and usable margin increases by the right at the amount of profit, right?
Very good.

Commander in Pips: Now let’s imagine that instead of reaching your profit taking level that your position has turned to loss again due say NFP release and your flow loss becomes greater:

Account Balance Total Equity Flow Profit/Loss Used Margin 100:1 Usable Margin
5000 € 4600 € 400 € 1500 € 3100 €


Account Balance Total Equity Flow Profit/Loss Used Margin 100:1 Usable Margin
5000 € 2500 € 2500 € 1500 € 1000 €

Until Finally:

Shaboom – broker has closed your position automatically, since your total equity has reached the minimum required assets value.

Action Account Balance Total Equity Flow Profit/Loss Used Margin 100:1 Usable Margin
- 5000 € 1500 € -3500 € 1500 € - €
-1.5 Lot
- 1500 € 1500 € - € - € 1500 €

 Hm, but I still can trade, right?

Commander in Pips: Yes, you can, since your broker allows you to trade mini accounts and your account balance will be sufficient to continue trading. You will not be able to trade when your total equity will be equal minimum margin at minimumal lot size. For instance, this broker allows you to trade no less than 0.1 lot with 100:1 margin. Hence, you will not be able to trade when your total equity will reach…

Pipruit: $100?
Commander in Pips: Yep.

Pipruit: Still, sir, I do not understand clearly. For example, the broker could close just part of my position and leave the rest opened. Why it has closed it totally?
Commander in Pips: Well, this is just an example. How it will be in reality depends on each particular broker and its rules of management client’s positions. You have to study trading rules of any particular broker. Also, if you have some different lots in different currencies, the broker could close one or few positions and leave some others open. This is a bit personal and depends, as we’ve said from broker.

So, let’s make some conclusions:

1. Total Equity = Account balance +/– Profit/Loss on opened positions (flow profit loss)

When no opened positions hold Total Equity = Account Balance

2. Used Margin = Number of lots opened x margin per lot = position value x percent margin;

3. Usable Margin = Total Equity – Used margin, hence:

- No margin call if Total Equity>Used margin

- Margin call if Total Equity<= Used margin

Pipruit: Yes, I remember that.​

Commander in Pips: Also be aware that some brokers make close trades at earlier level, for example, if usable margin drops to less than 20% of total equity. You must read a brokers trading terms before opening an account.

And finally just single notification could be made about over leveraging. What happens in our example, if you have entered with 4 lots, instead of 1 (although 1 lot is too large for 5000 EUR deposit)? If market just moves for (25 pips – bid/ask spread) – you will blow out your account. Just imagine – only 25 pips and you will lose all of your money that you’ve accumulated during the long time you saved up to open the account. Here is a cost of over leveraging.

- Margin and leverage is double-edged sword. They increase your financial power by allowing control of larger amounts of money. From the other side they proportionally increase your risk;

- Study to control your assets on account. Be sure that you 100% understand how Balance, Equity margin change and what do they depend on;

- Study with scrutiny broker’s agreement and understand how client’s positions are managed. You have to 100% understand how positions will be closed at margin call and what conditions of margin call are;

- Some brokers increase margins for weekend days, as a rule 2 times. For example, if you have 1:40 leverage at week days – you will have just 1:20 at weekend – find out this issue with broker that you are trading with. If you are using 1:25 and they change to 1:20, you could get a margin call.

 Huh, I suppose that a standard lot will not exist for me for a considerable period of time.
Commander in Pips: This is not worst decision, son.


Table of Contents