I am trying to figure out the impacts of Leveraging through the use of an example as follows:
My balance = £5,000 GBP
I open a sell order @ a price of 1.3354 for 50,000 units
My S/L is 100 Pips
According to the calculator on babypips.com, my risk for this would be £400 i.e. if my S/L is triggered, I lose £400.
My question is: How much do I owe to my broker? Since my understanding is that I did not have enough of my own money to afford to open a sell position for 50,000 units, that means the broker did borrow me some money (?).
Therefore, if this trade goes against me and I lose £400 - how much do I also owe my broker?
Your broker will never lend you money. Therefore, you will never owe your broker money – except in the most extreme (and rare) circumstance, such as a so-called Black Swan event, which we won’t even get into in this post.
The misconception about possibly owing your broker money comes from another misconception
– the misconception that you buy or sell currencies when you trade. There is no buying or selling of currencies or currency pairs in retail forex trading.
When you place a trade, you are essentially placing a bet with your broker. Before your broker will accept your bet, he requires that you have a certain amount of money in your account – called margin – which serves the purpose of protecting a small portion of your account from loss. Think of margin as a security deposit, which will be refunded to you, when your trade is closed.
You can lose almost all of your account through bad trading, but you can’t lose that last portion, the margin amount. When your losses are threatening that last portion, your broker will close your position in what’s referred to as a forced liquidation. At that point, you will still have that margin amount in your account, but that’s all you will have.
If you ever burn your account all the way down to the point of a forced liquidation, it means that your trade management and/or money management are lousy, or nonexistent. Sensible traders don’t let their trading result in forced liquidations.
To use the example in your post, the position you took (50,000 units of GBP/USD) requires margin. Let’s say the initial margin percentage is 2% of the notional value of your position. And let’s say that immediately after you open this position, the required initial margin is replaced by a lower margin amount, called maintenance margin, which is half of the intial margin.
Okay, let’s plug in the numbers.
50,000 units of GBP/USD (or any other pair of the form GBP/XXX) has a notional value of £50,000. This is 10 times the amount in your account. That is, you are using 10:1 actual leverage. This use of leverage is reasonable.
Required initial margin is £1,000 (that’s 2% of £50,000). You have more than that in your account, so your broker accepts your order to place this trade. Immediately, the margin required to stay in your trade (the maintenance margin I mentioned above) replaces the initial margin. That maintenance margin amount is £500. This is the amount you absolutely cannot lose, no matter how badly you manage your trade.
In your example, your position is stopped out, costing you £400. As soon as your stop-loss is hit, that £400 loss is charged against your balance, and the £500 margin is released back to you. Your balance is now £4,600. You have no open position. None of your money is tied up in margin. And you don’t owe your broker any money.
You did not buy or sell anything. In this business, we use the terms “buy” and “sell”, because those terms are convenient. But, they can be misleading to newbies.
Burn this into your brain:
In the retail forex market, there is no buying or selling, and there is no borrowing.
You my friend are a Legend with the capital L! You just cleared up so much confusion for me in your epic post, I don’t know how to pay you back… thank you so much man.
Can you tell me what it means when a broker has a sign on their website saying “losses can exceed deposits”?
It means that no negative balance protection is applied here. It means that the balance of your account can become negative without any limits and then you need to cover this minus. So I agree with the others that you definitely need to look for another broker.