Leverage and margin call are two concepts whose definition may have nothing to do with it, but they can commonly come hand in hand, hence we are going to talk about both in the same lesson.
What is leverage?
Leverage is a tool that allows you to trade large volumes with a much smaller amount of money available. This allows you to shoot profits in the same way that it allows you to shoot losses. The most common leverage in forex is 100: 1 and 200: 1, although it can be seen up to 1000: 1. In brokers in the United States, the maximum leverage allowed was limited to 50: 1 by the CFTC.
To explain the concept, let’s take a leverage of 100: 1 as an example. These numbers do not mean more than the possibility of using 100 times more capital in a trade than the capital held in the account, so if you have 1,000 USD, you could make a trade for a volume of 100,000 USD. Now you will say, good, so I can make lots of money with a small initial investment. Stop for a second and let’s see how leverage works.
Let’s assume a mini account of 1,000 USD with 100: 1 leverage in which you can trade at least 1 micro lot . What will happen if you have a negative trading streak of -50 points ?:
|Operation||Using 0.01 lot (1% initial leverage)||Using 0.1 lot (10% initial leverage)||Using 1 lot (100% initial leverage)|
You will not be able to continue trading with 1 lot, you can open a trade with 0.50 lots maximum
|2||990||900||250 You can no longer trade 0.50 lots, you would have to do it with 0.25 lots maximum.|
|3||985||850||Margin Call : If you continued using 100% leverage, your broker will have made you a margin call closing all your operations (see below the explanation of the margin call).|
As you can see, losses soar as the leverage used is increased. In the same way, profits will increase by increasing leverage if the operations are winning but the associated risk is too high. Nobody in their right mind with a more or less professional Forex vision will use 100% of the margin in a single operation.
Margin is the amount of money in the account required as collateral for operations. It is calculated based on the size of the trade and the leverage used. For example, if we trade with 1 lot (100 thousand coins) and our account has a 100: 1 leverage, our required margin, if the base currency is USD, will be 100,000 / 100 = USD 1,000. This means that for each lot traded we need to have 1,000 USD in the account (if the base currency (the first in the pair) is not USD, it will have to be converted to USD, in the lesson “Where does the profit come from? The pip and the lot ” there are examples of how to go from one currency to another).
The free margin is that available to make operations. Following the example above, let’s say you have an account with $ 2,000 and 100: 1 leverage. You open a trade with 1 lot, which requires an available margin of 1,000 USD. After opening the trade, you will have a free margin of 1,000 USD.
Continuing with the margin call: If your losses leave your free margin below the margin required to cover open positions, your broker will make a margin call and close all your operations. As your operations at those moments add significant losses, operations are closed as a security measure for the broker to prevent you from ending up with a negative balance, it prevents anyone from ending up owing money to anyone.
Example: You have an account with 10,000 USD, 100: 1 leverage, you open a trade with 1 lot. Your used margin is $ 1,000 and your free margin is $ 9,000. If your losses exceed 9,000 USD there will be a margin call.
Let’s complicate the story a little more. Now we must talk about the margin requirement. So far I have talked about the margin and free margin in absolute currency terms, but the most usual thing is that it is expressed as a percentage (or both times 1). Each broker establishes a margin requirement in its rules , always complying with what is dictated by the regulatory bodies, this being the free margin required to cover your operation. For example, if the broker with which we operate in our previous example has a margin requirement of 25%, it means that if your free margin drops to 25% or less, it will apply the margin call even when the margin necessary for the operation is 10%. So it is very important to know the margin requirements of your broker !!! .
Example: Continuing with the previous example, we have an account with 10,000 USD, 100: 1 leverage and our broker has a margin requirement of 25%. If we open a 1 lot trade, we have used 10% of the margin (or 0.10 if it is expressed in terms of 1) leaving a free margin of 90%. In this case, according to the rules of our broker, if our free margin falls to 25% or less, we will make the margin call even when the margin necessary for the operation is 10%. Therefore, I repeat, it is important to know the margin requirements of our broker. Translating this into money, if our losses exceed 7,500 USD we will suffer the margin call and our trade will be closed even if the margin necessary for the position we open is 1000 USD.
Please note: Some brokers increase their margin requirements on weekends. So if you plan to keep open positions during the weekend, find out about the policy of your broker. There are brokers with a margin requirement of 30% and higher.
Margin requirements, leverage and the risk that surrounds them must be understood, in the same way, you must know the margin policies of your broker and feel comfortable with them.