Chapter 3: Leverage, Margin, Lot & Pip
Aside from the stop loss a big role in risk management also have leverage, margin, lot size, and pip value. Understanding them well and how different combinations between them can have very different implications for your account is absolutely critical for your long term success in Forex trading. Let’s get into each and explain them:
Margin and leverage are always tied to each other, you can’t have one without the other.
Leverage in Forex trading refers to the option traders have to borrow money from the broker in order to open positions. Usually, brokers offer several hundred times borrowed money than what the trader has to put in the position which is known as the margin. For example with a 500:1 leverage the trader can open a position of 1 lot ($100,000) with just $200 of his own money. The other $99,800 are borrowed from the broker.
The $200 that the trader must have in order to open a position of 1 lot is called the margin, and the other $99 800 are the leverage on the margin, 200 * 500 = $100,000.
Leverage is known as the notorious killer of Forex traders, and because of this it is restricted in some countries, for example in the USA Forex brokers can provide a maximum of 50:1 leverage to their customers. Now, the truth is that really leverage by itself can not harm you. It is not understanding how to use it correctly that really does the damage to traders. It’s critical to understand that leverage works against you as much as it works for you.
A margin call is something that you don’t want to have in your trading career. It basically means you’ve lost a lot of money and in some cases of very high leverage it can mean you’ve lost all the money in your account.
To better understand how a margin call occurs, first, let’s see what is free margin. To use our example above, let’s say that the trader has a $1,000 in his account. With his position of 1 lot and a margin of $200 he has $800 free for other trades, which is known as the free margin.
Free margin is important because you only get a margin call when your free margin reaches 0, at which point your broker automatically closes some or all of your open positions. After this, you are left with only as much money as your used margin was.
So, free margin is calculated by subtracting the used margin from the account equity, not the account balance, although it may seem more natural. In this regard, you can see how your equity has to be dropping in order to receive a margin call. If your trades are profitable you will not receive a margin call. However, by using very large leverage even with a very small market move you can receive a margin call because the leverage will multiply your losses.
The lot size determines how much money you put at stake in each trade. Most commonly forex brokers offer 3 types of lot sizes to trade with.
- 1 lot = 100,000 units of the base currency
- 1 mini lot = 0.1 lot = 10,000 units of the base currency
- 1 micro lot = 0.01 lot = 1,000 units of the base currency
Sometimes you may also find nano lots:
- 1 nano lot = 0.001 lot = 100 units of the base currency
The base currency is always the fist quoted currency, for example for EURUSD the base currency is the EUR and in the case of GBPCHF, the base currency is the GBP. This is good to know because you are always opening your positions in the base currency, thus, any profits or losses you incur are calculated in the base currency.
So, depending on which type of lot you use you will be exposing your account to a different magnitude of risk.
Pip value is another thing to keep an eye on. Most traders don’t understand this correctly, and it can be confusing, but basically what you need to know is that each currency pair has its own pip value which is calculated by the quoted currency, or the second one in the quotation like the dollar in EURUSD, GBPUSD, and AUDUSD.
For pairs where the greenback is the quoted currency, the pip value is always $1. However for other pairs with a different quoted currency, the pip value is calculated in that currency. For example for EURGBP, the pip value is calculated in GBP and for the size of 1 standard lot, the pip value will be 10 GBP.