Leverage & Margin – Key Principles Of Forex
There are two main ways that retail Forex traders are able to have enough financial capacity to access the Spot (instantly executed trades opened on the spot) retail Forex markets in the United Kingdom: one is to spread bet, which is classed as gambling and where you bet on a currency pair going up or down and where you pay no income tax on your winnings. The other way is to trade Contracts for Difference (CFD), and where your winnings are subject to capital gains tax and any losses can be offset against taxable income.
Retail Forex traders who trade via CFDs are able to gain market access due to a system of leverage (AKA margin ratio). Therefore, a trader with a fairly modest trade account of £1000 pounds is able to effectively borrow/control up to 30,000 units (AKA volume) of the base currency, or £30,000 pounds in order to trade the Pound against the US Dollar. This also depends on the pair’s exchange rate (GBP:USD where the Pound is the base currency. A base currency has more value than the counter currency on a unit by unit basis).
In this example, this would equate to approximately £3 per pip movement while trading in GBP:USD should the trader decide to take on the maximum allowed leverage ratio of 1:30 while utilising 3 mini lots per trade (100,000 units is equal to one standard lot, 10,000 is one mini lot and 1,000 is one micro lot).
But it wasn’t always like this: due to the the high number of novice retail traders (70% official statistics) losing all their deposited funds after just six months of trading, leveraged CFDs were restricted in 2018 by the European Securities Markets Authority (ESMA), in order to protect retail CFD Forex traders. ESMA imposed limits on regulated brokers who provide retail CFD Forex trading of 30:1 for major FX pairs and 20:1 for non-major pairs. Before this brokers were able to offer leverage of up to 1:500.
Therefore, leverage provides traders with the ability to trade large amounts of currencies for very little outlay. However, leverage is a double edged sword; because, by its nature it can greatly help to amplify winnings, but, it also increases the risk of substantial losses! One of the biggest reasons why retail traders losie their money is due to a lack of understanding and the misuse of leverage.
A Margin requirement is the amount of capital in an account that will be set aside in the form of a deposit, by the broker, in exchange for leverage, each time a trade is opened. Margin is calculated by the trader’s level of leverage and is effected by floating profit and loss and can therefore fluctuate up and down. Also, the more open trades the more margin will be set aside by the broker. Should traders open too many trades, or their account start to incur losses, they are more likely to receive a margin call from their broker as they approach their margin limit (a request to put more funds into their account to bring the margin into line) which would only happen in the event that the overall account position was running at a loss, assuming there were more than one trade open. If traders ignore margin calls they run the risk of their trades being closed out by the broker.
Margin call example
A trader wishes to buy EUR:USD with an account size of €1000 and buys 1 mini lot of 10,000 units with a leverage of 1:30, his/her margin is calculated as 10,000 divided by 30 = 333.
Therefore, the traders margin for that trade would be €333.00. If the trader loses money on the trade and comes close to the required margin of €333.00 in their account they would face a margin call / request to add further funds into the account. If the trader refused or neglected to do so, the broker would close the trade on their behalf.
Typically a traders platform will show a running profit and loss in the form of; account balance and fluctuating equity (this will differ if trades are open), the margin being taken up by open positions, free or available margin, and margin level shown as a percentage.
Leverage and margin requirement differ from one asset class to another. But, consistency and careful risk management is essential while considering how to factor these into your trading.