FX Margin Trading, also known as Leveraged Forex trading, is a popular method among individual traders for participating in the Forex market. It allows individuals to access the world’s largest financial market with just a small margin as low as $1.
Key takeaways:
- Forex leverage grants traders the ability to control larger positions , rather than amplying their capital.
- Forex margin refers to the deposit required to initiate a position, and the margin rate is interchangeable with leverage.
- The primary factor influencing trading risk is not Forex leverage, but rather the position size.
- Higher leverage allows for larger maximum position sizes, which is why leverage can be risky if not managed properly.
What is Forex Margin Trading
When discussing Forex margin trading, there’s a common misconception that Forex futures serve as its underlying market. However, FX margin trading is actually a form of Contract for Differences (CFDs) trading derived from the Forex spot market.
Although both belong to the family of the Forex market, spot Forex indicates the current price of currency that can be exchanged immediately, whereas Forex futures reflect prices that will be exchanged at future dates.
Characterized by high leverage, FX margin trading allows investors to trade a significant value of Forex contracts with a small deposit. This effectively lowers the threshold of Forex trading to a level that most individuals can afford. For instance, with a leverage ratio of 1:500, a Forex contract valued at $10,000 only requires a small margin of $20.
FX Margin & Leverage Meaning
Leverage and margin are two interconnected concepts that play a crucial role in Forex trading, understanding them correctly is the first step in learning to trade.
1). Leverage Meaning in Forex
Let’s begin by comparing two definitions of leverage in Forex trading:
| What is leverage in Forex trading | |
| Definition V1 | Leverage amplifies traders' capital |
| Definition V2 | Leverage enables traders to control positions with a higher value than their capital. |
The first definition is a common misunderstanding of leverage meaning in Forex. Leverage in Forex doesn’t amplify traders’ capital, instead, it gives traders the ability to control positions with a higher value than your initial capital.
For example, suppose we have $200 capital and decide to open a position valued at $10,000 using 1:500 leverage. The leverage doesn’t increase our capital by 500 times to $10,000. Instead, it allows us to control the $10,000 position while still having our initial capital of $200.
However, we will be responsible for managing the profit and loss of the $10,000 position with our relatively small capital.
2). What is Margin in Forex
In leveraged Forex trading, margin refers to the deposit required to open a position. Margin is closely tied to leverage, and their relationship is well explained by the following formula:
Forex Magin = Trading Value / Leverage
For instance, if you’re trading a position valued at $10,000 with 1:500 leverage, the margin requirements would be $200. Addtionally, the term ‘margin rate’ is often used interchangeably with leverage in FX margin trading. Please see two examples in below:
- The margin rate 1% is equivalent to 1:100 leverage.
- 1:500 leverage is equivalent to 0.2% margin rate.
How to Calculate Forex Margin
In the previous section, we provided a formula for calculating Forex margin. However, we left a term ‘trading value’ unexplained. To further clarify, let’s introduce two connected terminologies: Forex lot size and base currency.
FX margin trading is conducted in lot sizes with a fixed increment of 0.01 lots. 1 lot represents 100K units of the base currency.
1 lot in Forex = 100K base currency
The base currency is the currency listed on the left side of a Forex pair, while the one on the right side is the quote currency. For example, in USD/JPY, USD is the base currency, and in EUR/USD, EUR is the base currency. When buying one lot of USD/JPY, the trading value will be 100K USD. Similarly, buying 0.1 lots of EUR/USD equates to a trading value of 10,000 EUR.
Now, we can break down the formula of Forex margin calculation to below:
Forex Magin = (Trading lot size × 100K × Base currency) / Leverage
Free Margin & Margin Level
As we’ve covered the concept of Forex margin, it’s important to also understand two other key terms: free margin and margin level. Both of these terms can have an impact on the trading profit and loss.
1). Free Magin in Forex
Free margin in Forex refers to the margin that remains available and can be used to absorb floating profits and losses, as well as to open new positions. It fluctuates in accordance with the floating profit and loss of open positions.
There are two ways to calculate the free margin in Forex:
- Free margin = Balance – Margin + Floating P&L
- Free margin = Equity – Margin
These two calculation methods can be verified in the trading example shown in the screenshot above. We opened a long position on USD/JPY with a lot size of 0.01 lots and leverage of 1:500. The margin requirement is $20, which aligns with the calculation using the formula provided in the previous section.
2). Margin Level in Forex
Margin level in Forex is a critical metric used to monitor margin call, which can trigger the forced liquidation of open positions. Below, you’ll find the formula for calculating margin level in Forex:
Margin level = Equity / Margin
Forex brokers set the margin call rules based on the margin level. When the margin level falls to a specific threshold, such as 50%, the margin call is triggered, leading to forced liquidation actions.
The margin level in Forex simply indicates the percentage relationship between the account equity and the margin requirement. A higher margin level is generally considered better.
How to Calculate Forex P&L
Now that we have a grasp of the basics of FX margin trading, let’s delve into calculating Profit & Loss (P&L). There are several approaches to this calculation, but we recommend using the P/L for one unit method. We’ll break down the calculation into three steps:
Step 1: Calculate the P&L for One Unit
The P&L for one unit refers to the profit or loss incurred from trading a single unit of currency. It can be calculated using the following formula:
- Long position: P&L for one unit = (Close price – Open price) × 1 quote currency
- Short position: P&L for one unit = (Open price – Close price) × 1 quote currency
Example of long position
Buy 1 lot USDJPY at 150.050
Close the position at 150.585
P&L for 1 unit = 150.585 – 150.050 = 0.535 JPY
Trading P&L = 0.535 JPY ×1 lot × 100K = 53,500 JPY
Example of short position
Buy 1.5 lots EURUSD at 1.08792
Close the position at 1.08250
P&L for 1 unit = 1.08792 – 1.08250 = 0.00542 USD
Trading P&L = 0.00542 USD ×1.5 lots × 100K = 813 USD
Step 2: Add Up the Total Trading P&L
Once we have the P&L for one unit, the total trading P&L can be added up using the following formula:
Trading P&L = P&L for one unit × lot size × 100K
Step 3: Currency Conversion on Trading P&L
If the trading P&L is in a currency other than the account denominated currency, it needs to be converted. This conversion will be done automatically by the trading platform, using the real-time exchange rate at the time of closing the position.
Forex Leverage and P&L Link
Does leverage impact the P&L in Forex trading? Yes, but not directly. The primary effect of leverage is on the lot size of the position that a trader can open. The position size is the determining factor for the resulting P&L in leveraged Forex trading.
If we open a long position on EUR/USD at 1.08200 and close it at 1.08655, let’s compare the difference in P&L between two different lot sizes:
- P&L for 0.1 lots: (1.08655 – 1.08200) × 10,000 = 45.5 USD
- P&L for 1 lot: (1.08655 – 1.08200) × 100,000 = 455 USD
As clearly demonstrated in the comparison, larger position sizes entail higher P&L risks. While Forex leverage itself isn’t directly tied to the P&L, it does influence the margin of the position opened. In other words, leverage determines the maximum lot size a trader can open.
For instance, with a $500 capital, the maximum lot size on USD/JPY with 1:500 leverage is 2.5 lots, compared to 0.5 lots with 1:100 leverage. When higher leverage is available, some traders may struggle to control themselves from opening larger positions. This is why it’s often emphasized that higher leverage leads to higher risk.
Best Forex Leverage for Beginner
Many beginners often wonder about the best leverage for Forex trading. However, there is no definitive answer to this question, in fact, the question itself is flawed.
The more appropriate question to ask is what level of risk is suitable for beginners in leveraged Forex trading. As discussed in the previous chapter, lot size is the determining factor in trading risk. Therefore, the best approach is to consider the appropriate lot size that a beginner should open.
Several factors need to be taken into account to answer this question, including but not limited to initial capital, risk tolerance, and trading duration. Let’s explore an example in below:
$200 capital in hand
Plan to trade EURUSD with the leverage of 1:500 and want to stay safe for at least a week.
EURUSD weekly fluctation in pips is around 300 pips
The appropriate lot size for a $200 capital to withstand a 300 pips fluctuation on EURUSD is 0.05 lots.
This example illustrates the logic of evaluating and calculating the risk in leveraged Forex trading. It is a complex process that requires professional knowledge. However, the key factor influencing trading risk is not leverage, but rather the position size.
Good Leverage for Forex Beginner
If there is no best leverage, what constitutes a good leverage for Forex beginner? In reality, with a solid understanding of risk management, any common leverage such as 1:100, 1:200 and 1:500 can be effective. We will explain this by discussing the pros and cons of high leverage.
1). Pros of High Forex Leverage
Under the same capital and lot size, higher leverage can even provide an additional trading edge. We will illustrate this with an example. Suppose we have $200 capital in the account and intend to open a 0.1 lot (10K) position on USDJPY. Let’s examine the differences between using 1:200 and 1:500 leverage:
- 1:200 leverage – Margin: $50 | Free margin: 150
- 1:500 leverage – Margin: $20 | Free margin: 180
Free margin represents the available capital that traders can use to manage floating P&L. When free margin reaches zero, assuming a margin call level of 100%, a margin call is triggered, resulting in the liquidation of the position. In this scenario, a leverage of 1:500 provides additional flexibility in managing floating P&L.
2). Cons of High Forex Leverage
Does higher leverage always offer benefits? The issue stems from the fact that many traders find it difficult to restrain themselves from opening larger positions, particularly during periods of losses.
For instance, with a position size of 0.1 lots on EURUSD and a $200 capital, one can maintain safety for at least one or two days. Conversely, increasing the position size to 1 lot could result in liquidation within a matter of minutes.
In summary, it’s recommended to begin trading with the smallest lot size of 0.01 lots (1K), and a leverage of 1:200 is generally considered good enough, even with just $20 in capital. As traders gain experience and confidence, they can incrementally adjust their leverage to a level that aligns with their capital size and trading strategy.
