Leverage, Margin and Equity

 

In this lesson, we will learn about other three concepts that is very important for every traders to control their trade as well as how to calculate loss or profit.

 

What is Leverage?

 

Now, you are probably thinking "It's need hundreds of thousands of dollars to open a trade in forex. This game must be for millionaires, not me". Don't worry, you are still able to trade because there is a powerful tool called "Leverage". Having leverage means you can borrow money from your broker to trade a volume greater than the amount of money you have in your balance. Leverage is the ratio between the amount of money you really have and the amount of money you can trade. It is usually expressed by 1:x format. You have to make an initial deposit to your broker in order to receive leverage from them.

 

For instance, if your account balance is $1000, your broker will agree to lend you $99,000. Then you can open a position with volume up to $100,000. You are able to manage (or control) an amount of $100,000 with just $1000 in balance. In other word, you can trade an amount of money 100 times larger than the actual amount in your balance. In this case, your leverage is 1:100 or 1% in percentage.

leverage

There are a number of leverage levels that a broker willing to provide to clients. It may vary from 1:1 to 1:1000 or even more due to each broker's policy.

 

Your balance

Leverage

Leverage percentage

Your maximum trade size

$1,000

1:1

100%

$1,000 (0.01 lot)

1:50

2%

$50,000 (0.5 lot)

1:100

1%

$100,000 (1 lot)

1:200

0.5%

$200,000 (2 lots)

...

...

...

1:1000

0.1%

$1,000,000 (10 lots)

Note that the leverage just helps you to increase your trade size, not to share your profits or losses. Your profits or losses is reckoned into your balance, the borrowed money of leverage is untouchable and it will be returned to the broker in former state after each trade. Let's see the impact of leverage on trading result in the example table below:

 

Origin account balance $1000
Leverage level 1:100 1:200 1:500
Max. trade size available 1 lot 2 lot 5 lot
Pip value $10 $20 $50
Profit 10 pip Profit amount +$100 +$200 +$500
Result $1100 $1200 $1500
Loss 10 pip Loss amount -$100 -$200 -$500
Result $900 $800 $500

As you see, the higher leverage you use, the larger volume you can trade, thus the more profit or loss you will receive or suffer. Leverage is always interesting as well as dangerous for all forex traders. They said that leverage is like a double-edged sword because it will be a poweful weapon or kill you in a second depend on you can fully control it or not. Leverage magnifies both your profits and losses because it  increase your profits the same way it would increase your losses.

 

Using too low leverage may make your trading result unsignificant and you can't take the advantage of the forex market. Otherwise, using too high leverage may make your trade risky and out of control. We will find out more about the impact of leverage in another part.

 

What is Margin?

 

Basically, margin is the amount of money you are required to deposit at your brokers in order to open and maintain your trade on the market. Your broker will put required margin aside from your account balance to keep your position open. Margin can be expressed as either a percentage of trade size (as margin level) or amount of account currency (as required margin). Let's assume that your account currency is USD and your leverage is 1:100. Look at some examples to have it clear:

 

1. You want to buy 1 lot (or 100,000 units) of USD/JPY. Your gross margin to make this trade is 100,000 USD. But because your leverage is 1:100 (or margin level 1%), your actual required margin is only 100,000 x 1% = 1,000 USD.

 

2. You want to buy 1 lot (or 100,000 units) of EUR/USD at price 1.25000. Your gross margin is 100,000 EUR, which is equivalent to 100,000 x 1.25000 = 125,000 USDBut because your leverage is 1:100 (or margin level 1%), your actual required margin is only 125,000 x 1% = 1,250 USD.

 

3. You want to buy 1 lot (or 100,000 units) of EUR/JPY while EUR/USD price is 1.25000Your gross margin is 100,000 EUR, which is equivalent to 100,000 x 1.25000 = 125,000 USDBut because your leverage is 1:100 (or margin level 1%), your actual required margin is only 125,000 x 1% = 1,250 USD.

 

From examples above, we can summary the formula to caculate the required margin as follows:

 

Required Margin = Amount of base currency x Rate of (Base currency/Account currency) x Leverage percentage

 

Margin can be either "free" or "used". Used margin is another name of the required margin that we have just mentioned above. Free margin (also called "available margin") is the rest money in your account after used margin was held. It is also the available money to open new trades or incur the loss of current trades.

 

What is Equity?

 

Equity is simply the account balance plus the total current profits/losses of opening trades. Equity expresses the "temporary" total value of your account at the current time. Therefore, equity can be also considered as "floating balance" or "realtime balance" since it will become your new real balance if you close all your trades immediately. The following illustration shows the relation of all these factors:

 

margin equity balance

 

You will see that the equity will be higher than your balance when you having profits and lower than your balance when you suffering losses. The equity is calculated by this formula:

 

Equity = Balance + Total Floating Profits (or Losses)

 

For example:

 

Balance

$1,000

Total floating profits (or losses)

$100

-$100

Equity

$1,100

$900

 

When you have no trade: Equity = Balance = Free Margin.

 

If the equity is lower than a specific percentage of your required margin, which called "Stop-out" level, your broker will automatically close the most losing trade in order to release the margin of that trade. This will help you to prevent further losses and keep your balance at a specific stop-out level after you suffer maximum losses.

 

There is another factor called "Margin Call". It is the percentage level of balance that your broker will alert you before it reachs stop-out level. Margin call level is always greater or equal to stop-out level. Margin call is just like an warning before an action, so stop-out level is what we should take care about. Stop-out and margin call level applied to each type of account are different from broker to broker base on their policies. Have a look at example below to compare the effects of different margin call and stop-out levels:

 

Required margin

$1,000

In the case

Case 1

Case 2

Margin call level

100%

50%

Stop-out level

100%

30%

Floating losses

-$2,000

-$2,500

-$2,700

Equity

$1,000

 

(100% of required margin)

$500

 

(50% of required margin)

$300

 

(30% of required margin)

Action

Margin call & stop-out at the same time

Margin call (Alert)

Stop-out (Auto close the trade)

Balance after

stop-out

$1,000

 

$300

With higher stop-out level, you may suffer less maximum loss but your trade may be auto-closed earlier before it maybe turned into profitable one. In contrast, with lower stop-out level, you may suffer more maximum loss but your trade may have more chances to become profitable when the market change its direction that for you. Therefore, you have to check with your broker about these levels applied to your account in order to fully control your tradres.

 

How To Calculate Profit and Loss?

 

We have just digested the most basic important concepts of forex trading. Now let's move on to calculate profit and loss, which all traders want to know.

 

profit loss

 

With the same entry and exit point, your trade results in profits or losses just depend on your position is long (buy) or short (sell). You will have profits if buying in uptrend market or selling in downtrend market, and vice versa. Hence, we consider profit and loss as one factor that reflect the change in your balance after a trade. Profit or loss of a trade is calculated by following formula:

 

Profit (or Loss) = Amount of pips x Pip value for 1 lot x Amount of lots

or

Profit (or Loss) = Amount of pips x Pip value for 1 currency unit x Amount of currency units

 

You can use any of these formulas depend on which type of volume the trading platform used to open the position (lots or currency units). Let's assume that you buy 2 lots of EUR/USD at price 1.25000 then exit your trade at price 1.25300. The price moved 30 pips while pip value for 1 lot of EUR/USD is 100,000 x $0.0001 = $10. Let's calculate the profit:

 

Profit = 30 pips x $10 x 2 lots = $600

 

Remember that you have to deal with the spread when enter (open) and exit (close) a trade. Ask price will be applied when you open buy orders and close sell ones; Bid price will be applied when you open sell orders and close buy ones.

 

Again, you don't need to remember all these formulas, the trading platform will calculate it automatically. But it's better if you know how it works. Even when you want to pre-calculate it before trading, you can visit our calculators area.