module three
Leverage & Margin
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Most people are attracted to the forex market because they think they “can make a lot of money with little money, fast”. This is the result of the high leverage available in forex trading.
Leverage is at the heart of trading problems. It was leverage that brought down famous hedge funds like Long-Term Capital Management and the investment bank Lehman Brothers. Leverage has also ended millions of retail forex trading careers soon after they have started.
If you are in this for the long haul, you must understand leverage inside out, and you must understand the devastating impact of too much leverage. You must also understand the benefits of low leverage.
Margin
Your friendly forex/CFD broker gives and takes. It takes margin and gives leverage.
The broker takes your money and provides you with leveraged trading opportunities.
On the one hand, the broker will have a minimum amount just for you to open your account.
On the other hand, the broker wants a part of your margin as security for every trade you make.
Margin requirement
Margin required is expressed as a percentage of the notional value of the trade.
Leverage is limited by the margin required by your broker.
The required margin can differ due to the volatility of an instrument.
This is clear from the difference between the margin asked for EURUSD and BTCUSD.
EURUSD is not very volatile at all. Only a small amount (percentage) of margin is needed.
BTCUSD is very volatile. The broker requires much more margin for a BTCUSD trade.
The margin needed for EURUSD by a "good" unregulated broker is perhaps 0.5% to 1.0%
The same broker will ask for 50% or 100% margin in the case of BTCUSD.
That means either half your account, or your whole account.
The EU made the following leverage limitations on the opening of a pair:
For major forex pairs: 30:1
For non-major currencies, gold and major equity indices: 20:1
For commodities other than gold and major equity indices: 10:1
For individual equities and other instruments not already mentioned: 5:1
For crypto currencies: 2:1
Used Margin
This is the amount of margin used for a specific trade or trades. Thus, used margin as a percentage of account value will change as the equity changes. If a position is in profit, the percentage will decrease. If a position is in loss, the percentage will increase. But this information is irrelevant for determining risk.
Margin Call
If you opened a losing trade going at, say, -10%, and you allow it to get drawn down to -50% (of your account),
you only have the other 50% to open further trades. Desperately, you open more trades to recover from your losses. At some point, let's say at -75%, you will receive a 'margin call.' Long ago, it was a physical phone call.
In modern-day terms, your trades or some of your trades will be closed automatically.
Leverage
It is commonly accepted that leverage is something like borrowing money from your broker.
It is "like borrowing money from the bank to finance your mortgage". This is a terrible comparison.
It leads to wrong ideas like that you put down your margin as a deposit (like with the mortgage) and
borrow the balance (of the trade value) from your broker (like with the bank). Your broker is not a bank.
They don't have the money to finance contracts at their face value. Neither have their liquidity providers.
Notional value
In financial markets, specifically in margin trading, where parties agree to settle only the profits or losses resulting from price changes, the notional value refers to the full value of the contract, which typically remains constant. For example, a "standard" EUR/USD contract represents €100,000. If Trader A, with a $10,000 margin account, opens a position of one lot (one contract) and gains $500, the trader’s account will be credited with the $500 profit.
Leverage - details
Maximum leverage
We have seen that either regulators or unregulated brokers determine margin requirements for the
notional value of contracts to be traded. In the US, 2% of $100,000 usdchf = $2,000. Thus if the trader
has a $2,000 account he could at the maximum open one USDCHF contract of $100,000.
The maximum leverage refers to how many times the trader will be allowed to 'multiply' his account
value for a trade in a specific instrument. A US trader, trading at Oanda will be able to 50X his account
(at the maximum). That can be in one trade, or several trades open at the same time.
Leverage is expressed as a ratio. The maximum leverage in the US, for major FX is 50:1, therefore a US
broker, like Oanda, may indicate on their website they "offer" 50:1 leverage.
Remember: The broker determines maximum leverage .
Minimum leverage
The trader determines minimum leverage. This is relevant today because of micro accounts. As brokers
drop the minimum account sizes, while the minimum notional transaction values remain constant, the
trader can determine his minimum leverage depending on the size of this deposit (the amount of money
he gives the broker). For example if the broker requires a minimum of $100 his minimum leverage will be
10:1 if he opens a 1,000 units trade. But the trader can decide how much he wants to deposit and that will determine what the minimum for him will be when he opens a trade of 1,000.
If he has deposited $500, the minimum leverage will be 2:1.
Real leverage
The trader determines real leverage. In reality the leverage is zero until a trade is opened. If the trade is closed
the leverage is zero again. Maximum and minimum leverage are theoretical concepts. They indicate the
parameters within which a trader can 'operate'. The key word is "up to". The trader can decide how many
times he wants to leverage his account. Up to the maximum.
Calculating leverage
Leverage is not notional value divided by margin required like many seem to think. If it was so one will always
trade with the maximum leverage ratio, in which case it would be meaningless. Leverage is not meaningless.
It is by far the most important risk factor in margin trading. Leverage is the notional value of the open contract(s) you have, divided by the money in your account.
For example:
Trader A, a client of DayForex has a $10,000 account.
Trader A's broker, from Europe, advertise leverage of 30:1.
Trader A, as a client of DayForex understands the problem of too high leverage.
Trader A opens a trade of 30,000 units, i.e the notional value is (euro) 30,000.
Trader A knows his leverage will be 30,000 / 10,000 = approximately 3:1 (Approximately, because it is
30,000 euro, not dollar. But as a rule of thumb it is OK to equate, pip value with leverage ratio.
Position size: Notional value of the open contract(s) you have.
Pip value: Goes hand-in-hand with the leverage ratio. For example the pip value of one notional mini EURUSD contract (10,000 units) is $1.00. For a standard contract it is $10.00
To fully understand leverage and apply it in your trading you have to work with the relationship between pip value and position size and account value. Many traders are fixated on margin requirement even though margin requirement plays no important role in determining your factual risk. Position size relative to account size, expressed as a leverage ratio and pip value, does.
Leverage in "prop trading"
Notional value
When it comes to leverage, the key difference between trading your own account, or investor money and prop trading is when the primary leverage, which makes prop trading so attractive, is applied.
In classic trading your account is funded with real money. If you want outsized profits you have to leverage the funds in the account, by doing trades with face value higher than the account size in aggregate.
In "prop trading" the "primary" leverage is the direct link between the fee and the size of the potential funded account. Thus, in "prop trading" your payment ('investment') is leveraged +/- 200:1 before you open your first trade. In order to make outsized returns, relative to the fee (your 'investment'), you don't need more leverage than what you already have. If you pay $500 for a $100,000 account and make 50 pips with one lot (1:1) it is $500. That means without leveraging the trading account at all, you have doubled your 'investment.'
Surprisingly there are no additional "prop trading specific leverage limitations", like you would find in the world of real prop trading. For instance, I have traded on an investment fund. Initially with lower capital amounts - up to $1 million - the maximum leverage was 10:1. But when the amount was increased to $5 million, the maximum leverage was dropped to 5:1 by the risk manager.
In prop trading today you can trade as if you have 30, 50 or 100 times the virtual account value irrespective if it is a $5,000 or $200, 000 account. Thus the total potential leverage is insane. And it is insane to trade with anything approaching high leverage in prop trading. 10:1 leverage is high.
Summary
To fully understand leverage and apply it in your trading you have to work with the relationship between
pip value and position size and account value. Many traders are fixated on margin requirement. I don't
know why. Margin requirement plays no important role in determining your factual risk. Position size
relative to account size expressed as a leverage ratio and in the same breath pip value, does.
With prop trading primary leverage is upfront before trading, and should remain upfront.
Keep your leverage very low in your prop trading account.