Education - Articles & Tutorials - beginners forex trading lessons - LEVERAGE, MARGIN AND PIP VALUE - Lesson 5

LEVERAGE, MARGIN AND PIP VALUE - Lesson 5

In this lesson you will learn:

The concept of Leverage
What is a Margin
The importance of knowing the Pip Value

It is important for inexperienced traders and clients who are new to trading forex, or indeed new to trading on any financial markets, to completely understand the concepts of leverage and margin. Too often new traders are impatient to begin trading and fail to grasp the importance and impact these two critical success factors will have on the outcome of their potential success.

Leverage

Leverage, as the term suggests, offers the opportunity for traders to lever up the use of the actual money they have in their account and risked in the market, in order to potentially maximize any profit. In simple terms; if a trader uses leverage of 1:100 then every dollar they are actually committing to risk effectively controls 100 dollars in the market place. Investors and traders therefore use the concept of leverage to potentially increase their profits on any particular trade, or investment.

In forex trading, the leverage on offer is generally the highest available in the financial markets. Leverage levels are set by the forex broker and can vary from: 1:1, 1:50, 1:100, or even higher. Brokers will allow traders to adjust leverage up or down, but will set limits.

The initial amount that needs to be deposited into a Forex trading account will depend on the margin percentage agreed between trader and broker. Standard trading is done on 100,000 units of currency. At this level of trading the margin requirement would typically be from 1 - 2%. On a 1% margin requirement, traders need to deposit $1,000 in order to trade positions of $100,000. The investor is trading 100 times the original margin deposit. The leverage in this example is 1:100. One unit controls 100 units.

It must be noted that leverage of this magnitude is significantly higher than the 1:2 leverage usually provided on equity trading, or the 1:15 on the futures market. These increased leverage levels available on forex accounts are generally only possible due to the lower price fluctuations on the forex markets, compared to the higher fluctuations experienced on the equity markets.

Typically forex markets change less than 1% a day. If the forex markets fluctuated and moved in similar patterns as the equity markets, then forex brokers could not offer such high leverage, as this would expose them to unacceptable risk levels.

Using leverage allows for significant scope to maximize the returns on profitable forex trades, applying leverage allows traders to control a currency position worth many times the value of the actual investment.

Leverage is a double-edged sword however. If the underlying currency in one of your trades moves against you, the leverage in the forex trade will magnify your losses.

Your trading style will greatly dictate your use of leverage and margin. Use a well thought out forex trading strategy, prudent use of trading stops and limits and effective money management.

Margin

Margin is best understood as a good faith deposit on behalf of a trader, a trader puts up collateral in terms of credit in their account. In order to hold open a position (or positions) in the market place, margin is a requirement because most forex brokers do not offer credit.

When trading with margin and using leverage, the amount of margin required to hold open a position or positions is determined by the trade size. As trade size increases margin requirements increase. Simply put; margin is the amount required to hold the trade or trades open. Leverage is the multiple of exposure to account equity.

What is a Margin Call?

We have now explained that margin is the amount of account balance required in order to hold the trade open and we have explained that leverage is the multiple of exposure versus account equity. So let's use an example to explain how margin works and how a margin call might occur.

If a trader has an account with a value of £10,000 in it, but wants to buy 1 lot (a 100,000 contract) of EUR/GBP, they would need to put up £850 of margin in an account leaving £9,150 in usable margin (or free margin), this is based on one euro buying approx. 0.85 of a pound sterling. A broker needs to ensure that the trade or trades the trader is taking in the market place, are covered by the balance in their account. Margin could be regarded as a safety net, for both traders and brokers.

Traders should monitor the level of margin (balance) in their account at all times because they may be in profitable trades, or convinced that the position they are in will become profitable, but find their trade or trades are closed if their margin requirement is breached. If the margin drops below the required levels, FXCC may initiate what is known as a "margin call". In this scenario, FXCC will either advise the trader to deposit additional funds into their forex account, or close out all of the positions in order to limit the loss, to both trader and broker.

Creating trading plans, whilst ensuring trader discipline is always maintained, should determine the effective use of leverage and margin. A thorough, detailed, forex trading strategy, underpinned by a concrete trading plan, is one of the cornerstones of trading success. Combined with prudent use of trading stops and take profit limit orders, added to effective money management should encourage the successful use of leverage and margin, potentially allowing traders to flourish.

In summary, a situation where a margin call might occur is due to use of excessive use of leverage, with inadequate capital, whilst holding on to losing trades for too long, when they should be closed.

Finally, there are other ways to limit margin calls and by far the most effective is to trade by using stops. By using stops on each and every trade, your margin requirement is immediately re-calculated.

Pip Value

Volume size (trade size) will affect the pip value. Pip value by definition, measures the amount in change in the exchange rate for a currency pair. Currency pairs that are displayed in four decimal placed, one pip is equal to 0.0001 and for Yen that has two decimal places, is displayed as 0.01.

When deciding to enter a trade it is very important to know the pip value, particularly for risk management purposes. In order to calculate the pip value, FXCC is providing a Pip calculator as a useful trading tool. However, the formula for calculating the pip value for 1 standard lot is:

100,000 x 0.0001 = 10USD

For example, if 1 lot of EUR/USD is opened and the market moves 100 pips in the traders favor, then the profit would be $1000 (10USD x 100 pips). However, if the market went opposed to the trades favor, the loss would be $1000.

Therefore, it is important to understand the pip value before entering a trade in order to evaluate up to which level a potential loss would be acceptable and where a Stop Loss order may be placed.