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Lots, Leverage and Margin

Lots, leverage and margin are all pretty boring subjects. However, if you’re going to become a Forex trader, it is vital that you know about them all. One exception to this rule is traders from the U. K. who spread bet. Spread betting usually works differently. So, if you’re spread betting you should be able to skip this article.

What is a lot in forex?

In the previous article you learned what a pip is and how to calculate the value of a pip. You probably remember that we got some extremely low pip value, on USD/CHF one pip was worth only 0.00009250 USD.

Well, $0.00009250 USD is the value of a pip per unit and the standard size of a lot is 100,000 units of the base currency. To open a trade, you need to buy or sell one or more lots. So, if you open a long trade with one standard lot on USD/CHF, you would be buying 100,000 units. Since USD/CHF has a per unit pip value of $0.00009250 USD, your pip value would be $9.25 USD per pip ($0.00009250 x 100,000 units).

$9.25 USD per pip may sound like a lot. However, there are several different lot sizes in Forex:

Standard lot = 100,000 units of base currency

Mini lot = 10,000 units of base currency

Micro lot = 1,000 units of base currency

Nano lot = 100 units of base currency

Nano and micro lots are a fantastic way to trade Forex without risking much money. When you first start trading, you do not want to be trading standard lots. If each pip is worth $9 USD, and you lose 100 pips, thats $900 USD gone. Micro lots allow you to learn Forex without risking the house.

Now you can calculate the value of a pip per lot. The pip value we calculated in the previous article was based on a single unit. So, for every unit traded on a GBP/USD trade a pip is worth $0.00009998 USD. With a mini lot you have 10,000 units open, so each pip will be worth $0.9998 USD. Calculating how much you will make per pip on a trade is straight forward.

First step: Calculate the per unit value of a pip.

USD/JPY = 96.27

0.01 / 96.27= 0.0001038

1 pip = 0.0001038 USD per unit

Second step: Multiply the per unit value by the lot size you are using.

0.0001038 USD x 10,000 units = 1.038 USD

If the US dollar is not quoted first and you want the pip value in US dollars, the formula is a little different.

First step: Calculate the per unit value of a pip.

GBP/USD = 1.6443

0.0001 / 1.6443= 0.00006081

1 PIP = 0.00006081 GBP

Second step: Multiply the per unit value by the lot size you are using.

0.00006081 USD x 10,000 units = 0.6081 GBP

Third step: Multiply the value per pip by the rate of the pair.

0.6081 GBP x 1.6443 = 0.9998 USD

Round this up to $1 per pip.

These numbers still don’t seem very good. Why would you want to invest $10,000 and earn only $1 per pip? Well, with leverage, you don’t have to invest that much.

What is Leverage?

Leverage allows you to trade more units than you have. So if you have a mini account with a $1,000 (1,000 units) balance and you enter $100 (100 units) into a trade you can hold a $10,000 (a 10,000 unit) position. In this case, you would have 100:1 leverage. For every $1 you put into the market your broker puts in $99 to make it $100.

The important thing to remember about leverage is that it does not affect the value of a lot. You know that a mini-lot is 10,000 units of currency and a standard lot is 100,000 units. The value of these never changes no matter what your leverage is. If you have 400:1 leverage a mini-lot is still roughly $1 a pip. If you have 100:1 leverage that same mini-lot is still roughly $1 per pip.

Leverage does not affect the value of a lot but has an effect on the number of lots you can have in the market, based on the capital in your account.

The reason they call it leverage is because it is much like trying to lift a very heavy object. Some objects are just too heavy to lift. However, with the right leverage it’s easy. If you have 100:1 leverage you can trade a mini lot (10,000 units) with just 100 units.

Leverage may sound great, but it can cause problems too. The higher your leverage the more of your capital you can risk at one time, in comparison to a lower leverage.

If two traders have the same amount of capital, let’s say $10,000 USD, and one has 100:1 leverage and the other has 400:1 leverage, the trader with 400:1 leverage will be able to risk more of his $10,000 at one time than the trader with 100:1 leverage. The trader with 400:1 leverage is required to have less in their account to cover their position.

Let’s use some round numbers in order to better understand this concept. Again, take two traders with $10,000 USD in their accounts. Trader 1 takes a long position at 100:1 leverage on currency pair X/Y and buys 1 mini lot (10,000 units). Trader 2 takes the same long position at 400:1 leverage on currency pair X/Y and buys 1 mini lot (10,000 units).

Since Trader 1 has 100:1 leverage then he is required to have 100/1 or 1% of the position in his account. So for Trader 1 he will need to have at least $100 in his account which is 1% of 10,000 (1 mini lot). Since Trader 2 has 400:1 leverage then he is required to have 400/1 or 0.25% of the position in his account. For Trader 2 he will need to have at least $25 in his account which is 0.25% of 10,000 (1 mini lot).

Leverage be extremely dangerous. If you have $1,000 account with 400:1 leverage, for $100 you could trade four mini lots. If you take take a 100 pip loss on a trade, you could lose $400 on just one trade. You need to be very careful with leverage. In the end though, you are the one that determines the degree of your leverage. Your broker can only determine the maximum leverage allowed. If you choose to use the maximum that is up to you.

What is Margin?

Margin is a good faith deposit required by your Forex broker to cover the position you have entered into the market. Without providing this margin, you would be unable to use leverage as this is what your broker uses to maintain your position, and to cover any potential losses.

Different brokers will insist on different levels of margin depending on a number of factors such as the currency pair you are trading and the leverage of your account.

The currency pair you are trading is a factor in how much margin is required because each currency pair moves different. Youll tend to find that the more volatile pairs tend to move more in an average day. This means the margin required to trade those currencies is likely to be higher.

Also since margin is normally quoted in percentage terms, such as 0.25%, 0.50% or 1%, then this tends to increase as leverage decreases.

The easiest way to think of margin is that it is the 1 in the leverage ratio. So for instance, if your leverage is 100:1 your margin is how much is in your account (represented by the 1). This will dictate how much you can place in the Forex market. this means if you have a mini account and place a $10,000 position in the market, youll need at least $100 to even open the trade.

What’s a Margin Call and Should I be Afraid of one?

A margin call is what happens when you have no money left in your account. To protect you from losing more money than you have your broker closes out your positions. This means you can never lose more money than you have in your account.

Before learning what a margin call is you need to know the definitions of two terms.

Used Margin: The amount of money in your account that is currently used in open trades. If you have $6,000 capital in an account and you have $1,000 in an open trade then your used margin is $1,000. If you have $3,000 capital in an account and you currently have $600 in an open trade your used margin is $600.

Usable Margin: The amount of money in your account minus any open trades. We will continue from the same examples used above. If you have $6,000 capital in an account and you have $1,000 in an open trade your usable margin is $5,000. If you have a $3,000 capital in an account and you currently have $600 in an open trade your usable margin is $2,400.

When your usable margin reaches $0 your broker will automatically margin call you. With good money management this should never happen but newbies can slip up.

Below are a few examples of margin calls:

Tom opens a standard Forex account with $4,000 and 100:1 leverage. This means that on each trade Tom must enter a minimum of 100,000 units ($100,000). With 100:1 leverage Tom must enter $1,000 of his own money to each trade.

Tom analyzes GBP/USD and decides that the pair is going up. He opens a long position with 2 standard lots on GBP/USD. This means Tom is trading $2,000.

Disaster strikes GBP/USD goes down instead of up. Tom curses himself for taking a long but he keeps the position open. If Tom keeps the position open and it moves too far against him he will get a margin call.

Before Tom opens his position he has $4,000 in usable margin. After opening a position with 2 standard lots ($2,000) his used margin became $2,000 and his usable margin became $2,000. If GBP/USD drops by too many pips and Toms useable margin reaches $0 his broker will close out his trade. This protects Tom from losing more money than he has in his account.

Another example:

Mary opens a mini Forex account with $1,000 at 100:1 leverage. She analyzes EUR/USD and decides to go short. Mary enters 7 mini lots ($700) short on EUR/USD. Before entering the positions, Mary’s usable margin was $1,000. Now that she is in the trade her usable margin is $300.

Again disaster strikes and Mary’s trade goes against her. If Mary’s usable Margin reaches $0 her trade is automatically closed, so she cannot lose more money than she has in the account.

Margin calls are easily avoided if you trade sensibly. However, this is more advanced stuff that you will learn later in the free Forex course.

It is very important that you check what the margin polices are with your broker. Margin policies can differ from broker to broker so if you plan to open an account remember to ask.

By Nick Bencino

Last updated: May 1st, 2016

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