Hi, im 20, a student at the moment but keen to get into investing…
I was big on following the stock market for a while but have recently discovered the world of Forex trading - mainly because for my studies i am on a years internship abroad and have had to deal with exchanging currencies and exchange rates quite often as i visit home one a month…
Again, i am a newbie and im currently working my way through the babypips school… I had some questions about the whole leverage idea from a broker which i cant seem to find a direct answer to…
Ok so i understand that leverage is kind of like a loan your broker will give you and i understand the odds 100:1 etc… What i am confused about is:
Ok so if hypothetically, i opened an account and put £500 in there… And a broker gave me leverage of 100:1… I would be able to buy £50,000 worth of currency… If by some miracle - and again like i said for hypothetical example, i made £5,000 from that investment… I would then close the trade and that £5,000 would be my profit?
I read that as a trader, you are only liable to pay what you have in your account - i think… So if going back to my previous example, i lost all £50,000, what would i actually lose? I would just lose my £500 initial deposit? Im confused at how I will lose £50k of the brokers money but he will only keep my £500…
Well, let’s stop right here. Forget the loan analogy. I used to use it myself — but, it’s very misleading. In the forex market, your broker does not lend money to you. Period.
Your broker allows you to speculate on POSITION SIZES which are considerably larger than your account balance. This is referred to as LEVERAGE. If you want to think in terms of analogies, think of your forex position as a “bet”, and think of your broker’s maximum allowable leverage (100:1, in your example) as the maximum size “bet” he will allow you to place.
So, forget the whole idea of “loans”. Instead, learn this relationship —
Maximum Allowable Leverage and Required Margin are mathematically related as follows:
…and, conversely, [B]Required Margin = 1 / Maximum Allowable Leverage[/B]
Therefore, using your example of 100:1 maximum allowable leverage, all of your trades with this broker will be subject to a 1% margin amount (because 1 / 100 = 0.01 = 1%). We’ll use this fact in the answer to your next question.
Basically, yes.
I say “basically”, because for technical reasons, you couldn’t actually use every bit of your 100:1 leverage — but, you could use almost all of it. Let’s leave that little technicality for another time.
The point of your question is this: If you use leverage to make enormous profits, do you get to keep those profits?
And the answer to that is definitely “yes”.
Likewise, if you take enormous losses, those are yours, as well. But, your broker is not going to allow you to lose every last penny of your account (as you will see in a minute). And he [B]definitely[/B] is not going to allow you to lose any of [B]his[/B] money.
Okay, here’s where it all comes together.
First, we have to reduce that position size slightly, because of that little technicality I said we’d put off til another time. So, let’s reduce your position size to £45,000. That means that you are actually using 90:1 leverage.
Your broker requires a “margin amount” equal to 1% of your position. In this case, 1% of £45,000 is £450. Your broker will temporarily put £450 of your money out of your reach. That is, you can’t use it for anything, including to cover losses. Think of this margin amount as being in “escrow”, until your trade is closed. After £450 of your £500 account has been “escrowed”, you have £50 left to work with.
Next, your broker will deduct the “spread” from your remaining £50. On a position size of £45,000, the spread might be £18. It could be more or less, depending on which currency pair you are trading. Let’s use the £18 figure. This amount is immediately subtracted from the £50 you have to work with — so, [B]you now have £32 left to work with.[/B] That’s all you have to cover any losses which might occur in your position.
Suppose everything works out perfectly for you. Price immediately moves in your direction, you recover the spread (which can be thought of as an initial “loss”), and you start to make profit. If you close your trade while it’s showing a profit, all the profit is yours to keep. Your margin amount will be released back to your account, and your balance will now be £500 + all the profit from your trade. Pretty cool, huh? But, wait…
What if things don’t work out well for you? What if your trade immediately goes against you BIG TIME. Let’s say price takes off in the “wrong” direction, and doesn’t stop until it’s moved 100 pips against you.
Remember that you have only £32 available to cover losses. As soon as price has moved 7.2 pips against you, your £32 will be gobbled up, and your broker will close your position. (If he let you accumulate any additional loss, it would be coming out of that margin amount which was set aside — and he isn’t going to let that happen).
Now you know the real purpose of “margin” — it’s to protect your broker from taking losses caused by you.
So, after this failed trade, where do you stand? You get your margin returned to you. Your account has suffered a loss of £50 (£18 for the spread + £32 due to the negative price move). So, your balance is now £450. You have lost 10% of your account, possibly in a matter of seconds.
That big loss you were worried about (in your example, above) never occurred, because your trade was automatically aborted by your broker as soon as you had incurred a (tiny) loss of 7.2 pips. Watch live price action in almost any currency pair out there: You will see that 7.2 pips is essentially a random, and meaningless, fluctuation in price.
In your hypothetical £45,000 trade, you were basically saying: If price heads to the moon, right out of the gate, I’ll make a ton of money; but if price initially takes just a tiny, baby step backward, I’ll be kicked out of my trade with an unacceptably large loss.
Just wanted to say thank you to Clint for posting a very detailed answer - really cleared up a lot for me about the idea of leverage and made it easier to understand… I look forward to actively getting involved in the forex market!
I would like help about choosing right leverage from this account balance example of 500 £. Lets say I would like to trade with 10,000 £. Would be better to choose leverage 20:1 or is it different if I have 100:1 and open position with 5,000 £?
Ok think I found an answer. If want to trade 5000 £ it does not matter what is your broker leverage even if it is 1000:1 ? The answer is in used lots, so more lots more danger in trading? Its not laverage who kills accounts :5: but too much trading lots?
One more thing: Higher leverage is actually better choice, because you have lower margin used, margin available is bigger and margin close comes later?
You are [B]not[/B] wrong. You have it all figured out. Congratulations.
Your broker’s maximum allowable leverage is a LIMIT. It’s like a credit limit on your credit card. It has nothing to do with the sensible, prudent, responsible way that you will structure and manage your trades — just as a sky-high credit limit on your credit card has no bearing on how much credit you actually use.
Suppose your broker offered you INFINITE leverage. That would correspond to ZERO margin, and that would be a good thing.
That would mean that none of your money would be tied up in margin. Also, it would mean that your broker would automatically close all your positions, if and only if your account balance fell to zero. And you would want your broker to do that, because it would prevent you from losing more than your account balance (and ultimately owing your broker money).
You will never be offered infinite leverage; but you should take advantage of the highest leverage available to you, whether that’s 100:1 or 500:1 — or just 50:1, as here in the U.S.
Maximum allowable leverage (the leverage your broker advertises) is one kind of leverage. The other kind is the actual leverage that you choose to use. As you correctly pointed out, that kind of leverage depends on your position size — the number of lots you choose to trade.
You have complete control of the actual leverage you use (up to the maximum allowable leverage offered by your broker), just as you have complete control of the actual amount of credit you use (up to the credit limit imposed by your credit card issuer).
Can you abuse leverage? Absolutely, just as you can abuse personal credit.
Your objective in planning every trade should be this: Determine a sensible and appropriate STOP-LOSS, and then adjust your ACTUAL LEVERAGE (your position size) so that your overall risk (as a percentage of your account balance) is prudent.
What is the definition of prudent? For beginners, 1% - 2% of your account balance, per trade, is prudent risk. Later, after you have become consistently profitable, you probably will be experienced enough, and wise enough, to know when it is prudent to take on higher risk by using higher leverage.
For now, stick to 2% or less. If you do, your account will survive the learning process that you are beginning.
