Hopefully, we’ve done our job and you now have a better understanding of what “margin” is.
If you don’t know what margin is, or think it’s an alternative form of butter, please read our previous lessons.
Now we want to take a harder look at “leverage” and show you how it regularly wipes out unsuspecting or overzealous traders.
Before we begin, let the image below haunt you about the negative effects of using too much leverage and running out of margin.
We’ve all seen or heard online forex brokers advertising how they offer 200:1 leverage or 400:1 leverage.
We just want to be clear that what they are really talking about is the maximum leverage you can trade with.
Remember this leverage ratio depends on the margin required by the broker. For example, if a 1% margin is required, you have 100:1 leverage.
There is maximum leverage. And then there is your true leverage.
True leverage is the full amount of your position divided by the amount of money deposited in your trading account.
Let us illustrate with an example:
You deposit $10,000 in your trading account. You buy 1 standard 100K of EUR/USD at a rate of $1.0000. The full value of your position is $100,000 and your account balance is $10,000.
Your true leverage is 10:1 ($100,000 / $10,000)
Let’s say you buy another standard lot of EUR/USD at the same price. The full amount of your position is now $200,000, but your account balance is still $10,000.
Your true leverage is now 20:1 ($200,000 / $10,000)
You’re feeling good so you buy three more standard lots of EUR/USD, again at the same rate. The full amount of your position is now $500,000 and your account balance is still $10,000.
Your true leverage is now 50:1 ($500,000 / $10,000).
Assume the broker requires 1% margin.
If you do the math, your account balance and equity are both $10,000, the Used Margin is $5,000, and the Usable Margin is $5,000. For one standard lot, each pip is worth $10.
In order to receive a margin call, price would have to move 100 pips ($5,000 Usable Margin divided by $50/pip).
This would mean the price of EUR/USD would have to move from 1.0000 to .9900 – a price change of 1%.
After the margin call, your account balance would be $5,000.
You lost $5,000 or 50% and the price only moved 1%.
Now let’s pretend you ordered coffee at a McDonald’s drive-thru, then spilled your coffee on your lap while you were driving, and then proceeded to sue and win against McDonald’s because your legs got burned and you didn’t know the coffee was hot.
To make a long story short, you deposit $100,000 in your trading account instead of $10,000.
You buy just 1 standard lot of EUR/USD – at a rate of 1.0000. The full amount of your position is $100,000 and your account balance is $100,000. Your true leverage is 1:1.
Here’s how it looks in your trading account:
In this example, in order to receive a margin call, price would have to move 9,900 pips ($99,000 Usable Margin divided by $10/pip).
This means the price of EUR/USD would have to move from 1.0000 to .0100! This is a price change of 99% or basically 100%!
Let’s say you buy 19 more standard lots, again at the same rate as the first trade.
The full amount of your position is $2,000,000 and your account balance is $100,000. Your true leverage is 20:1.
In order to be “margin called”, price would have to move 400 pips ($80,000 Usable Margin divided by ($10/pip X 20 lots)).
That means the price of EUR/USD would have to move from $1.0000 to $0.9600 – a price change of 4%.
If you did get margin called and your trade exited at the margin call price, this is how your account would look like:
You would have realized an $80,000 loss! You would’ve wiped out 80% of your account and the price only moved 4%!
Do you now see the effects of leverage?!
Leverage amplifies the movement in the relative prices of a currency pair by the factor of the leverage in your account.