What is the meaning of Leverage and of a Margin Call?

We already mentioned a lot size of 100,000 units, but there are only a few forex traders who have enough money in their forex account to be able to trade with standard lots. Fortunately you can use the so called leverage while practicing forex trading, as a result of which only a limited percentage of the entire amount with which you’re trading, has actually to be deposited into your forex account. However a leverage has all the qualities of a double-edged sword….

In contrast to many other financial markets only a part of the money which you need to trade with, actually has to be deposited into your forex account. In fact you borrow the deficit balance from your forex broker. Attention please! It definitely isn’t possible for you to lose more money than the amount which has been deposited in your forex account!

Some forex brokers even offer a leverage of 400:1. In this case it comes down to the fact that you only need to have deposited 1/400 part of the amount you wish to trade with, into your forex account. If for example you want to trade a standard lot of USD/CHF, you’ll need to have an amount of $100,000:400=$250 in your account to be able to open this position.

Below you’ll see a chart showing the amounts which have to be deposited into your account in order to enable you to open certain positions.

forex leverage margin call

The advantage of leverage should by now be clear to the majority of you: when using a high leverage you’ll potentially be able to gain hugh profits in comparison with the size of your forex account.

An example

Note: For convenience’s sake I’ll leave the spread undone for this moment.

You have $500 in your account, you use a leverage of 400:1 and you buy a standard lot of EUR/USD, which is indexed at 1,2250. You sell your standard lot when the price amounts to 1,2300. So consequently you earned 50 pips.

As 1 pip with a standard lot in this case amounts to $10 (see the article “The value of a pip in forex trading”), you have won $10 x 50 = $ 500. So you just doubled your account!

But unfortunately in actual practice things seldom go like this….

Margin Call

We use for just a while the same example as shown above, with the exception that in that case the price is first going down amounting to 30 pips….

Since 1 pip is the equivalent of $10, a drop of 30 pips means that your account is going to decrease with 30 x $10 = $300. That signifies that your forex account has been reduced to $200 and except for the fact that of course it’s never pleasant to watch more than half of your forex account disappears like snow before the sun, there’s another problem appearing…….. the infamous margin call.

As you could have read above, the forex broker demands that in case of a leverage of 400:1 you’re obliged to have a minimum of $250 in your account. As soon as you’re going to reach this margin or ending up underneath it, the forex broker will close your position.

In the example in which the price at first drops 30 pips, you’ll consequently get a margin call and your position will be closed by the forex broker. So it’s of no importance at all, whether your trade eventually will still be going into the right direction. You will not get any chance whatsoever to take advantage of this development and moreover you have lost half of your account…

Leverage: A double-edged sword

Although by using leverage you could make more profits, on the other hand the danger of potential losses could be disproportionally greater. Moreover you should be constantly aware of getting a margin call. Therefore leverage is indeed a double-edged sword.

Be Sociable, Share!

Speak Your Mind

*