You should now have a better understanding of what “margin” means.
Please read our prior classes if you don’t know what margin is or assume it’s an alternative type of butter.
Now we’d like to take a closer look at “leverage” and demonstrate how it routinely wipes out naive or overzealous traders.
Before we begin, consider the graphic below, which depicts the negative consequences of utilizing too much leverage and running out of margin.
We’ve all seen or heard online forex brokers advertise their 200:1 or 400:1 leverage.
We merely want to make it obvious that what they’re really talking about is the utmost leverage with which you can trade.
Remember that the leverage ratio is determined by the margin required by the broker. For example, if a 1% margin is required, your leverage is 100:1.
Maximum leverage exists. Then there’s your genuine leverage.
True leverage is the “full value” of your position, also known as “notional value,” divided by the amount of money in your trading account.
Let us use an example to demonstrate:
You make a $10,000 deposit into your trading account. You purchase one standard 100,000 EUR/USD at a rate of $1.0000. Your position is worth $100,000 in total, and your account balance is $10,000.
Your genuine leverage is ten to one ($100,000 / $10,000).
“True leverage” is often referred to as “effective leverage.”
Assume you purchase another normal lot of EUR/USD at the same price. Your total position value is now $200,000, but your account balance remains $10,000.
Your genuine leverage has increased to 20:1 ($200,000 / $10,000).
You’re in a good mood, so you purchase three more standard lots of EUR/USD at the same rate. Your total position value is now $500,000, while your account balance remains $10,000.
Your genuine leverage has increased to 50:1 ($500,000 / $10,000).
Assume the broker asks for a 1% margin.
Your account balance and equity are both $10,000, your Used Margin is $5,000, and your Usable Margin is $5,000, according to the calculations. Each pip is worth $10 for one regular lot.
A margin call would be issued if the price moved 100 pips ($5,000 Usable Margin divided by $50/pip).
This would necessitate a 1% price shift in the EUR/USD pair, from 1.0000 to.9900.
Your account balance would be $5,000 after the margin call.
You lost $5,000, or 50% of your money, although the price changed merely 1%. That’s crazy.
Let’s imagine you ordered coffee at a McDonald’s drive-thru, then spilt it over your lap while driving, and then sued and won against McDonald’s because your legs were burned and you didn’t realize the coffee was hot. To cut a long story short, you put $100,000 instead of $10,000 in your trading account.
You only purchase one standard lot of EUR/USD at a rate of 1.0000. Your total position value is $100,000, and your account balance is $100,000. Your ultimate leverage is one-to-one.
This is how it appears in your trading account:
In this example, the price would have to move 9,900 pips ($99,000 Usable Margin divided by $10/pip) in order to obtain a margin call.
This indicates that the EUR/USD rate would have to fall from 1.0000 to.0100! This is a 99% or nearly 100% price change!
Assume you buy 19 more standard lots at the same price as the initial trade.
Your total position value is $2,000,000, and your account balance is $100,000. The true leverage you have is 20:1.
The price would have to move 400 pips to be “margin called” ($80,000 Usable Margin divided by ($10/pip X 20 lots)).
That means the EUR/USD price would have to fall from $1.0000 to $0.9600, a 4% drop.
If your margin was called and your trade was exited at the margin call price, your account would look like this:
You’d have suffered a $80,000 loss!
A loss of $80,000!
You would have lost 80% of your money and the price would have just moved 4%!
And you’d most likely look something like this.
Do you see how leverage works now?
The component of leverage in your account magnifies the fluctuation in the relative values of a currency pair.