Hello and welcome to another episode of the bulls vs the bears. This week, we are going to tackle the double-edged sword called Leverage and Margin. I call it a double edged sword because it can make or break you if you don’t handle them properly. Not only is it a deadly double edged sword, but it is also another elephant in the room that rookie traders don’t want to talk about. They are in so much of a hurry to gamble their money away and they fail to understand the grave impact that their kamikaze me might have on their trading accounts.
So guess what we’re going to do? We are going to find out what leverage and margin are. And then we are going to learn certain things we absolutely have to avoid doing when using leverage and margin. But first:
What is Leverage?
Basically leverage is the power to control a humongous amount of money with very little of your capital and borrowing the rest. Say you control a $100,000 trading position using the GBP/USD currency pair. And by the way, the money was borrowed from the broker, not a bank. Your broker then sets aside $1000 from your trading account. Since leverages are expressed in ratios, your leverage will be expressed as 100:1. Meaning you are controlling $100,000 with $1000. Let’s assume out of nowhere, your $100, 000 investment climbs up to $101,000 on that same $1000 account. Since your broker only has to set aside only $1000, you’d have gained cool 100%. Meaning you’d have gained $1000 on your initial $1000 investment. Let’s take a look at a leverage graph.
Now here is a nice little graph various leverages and their corresponding investments. Like I said, leverage can work for you and work against you. You just need to curtail your greed when deciding which leverage ratio you want to work with.
Now let’s assume $1000 on that same $100,000 investment. You’d have ended up with a humongous -100% loss on 100:1 ratio. Now you see why I say leverage is a double-edged sword? Next up is:
What is a Margin?
Well, basically a margin is the amount of money needed to open a trading position. It is usually used by your broker to maintain your trading position. How does your broker do this? Well your broker takes all other traders’ deposits, pulls these deposits with those of everyone else, and then uses this huge deposit to be able to place trades. Margin is also viewed as a percentage of the full amount of the trading position. For instance you hear a lot of brokers say they require 2% 1 % or .5 margin.
Based on the margin required by the broker you calculate the maximum leverage you can mater with your trading account. So if your broker requires a 2% margin,you have a leverage of 50:1. Going back to earlier example,the $1000 deposit is now your margin you need in other to get your leverage. Below is an illustration of tempting leverages that some brokers offer:
|MARGIN REQUIRED||MAXIMUM LEVERAGE|
These leverages look very tempting. But like I’ve said, it can be a double-edged sword and detriment to your trading account. So watch out. But there are a few margin calls you need to know. First off:
Margin Required – Money broker requires from you to open a trading position.
Account Margin –Total amount you have left in your trading account
Used Margin – The amount of money that your broker has locked up to keep your trading positions open. Basically your broker is telling you”your money is still yours. But we can’t let you touch it, until you close your current positions or you receive a margin call. Speaking of which:
Margin call is where the amount of money in your account is unable to cover an impending loss.This happens when your equity falls below your used margin. In such a scenario, your broker will close all open positions at the market price. Let me explain the margin call a little bit. You open a $10,0000 account. Upon login in to your account you see the $10000 nicely published in the “Equity column” of your “Account Information” window. See it below.
As you can also see,your used margin for now is indicated and your usable margin(Cash available) is $10000.While balance and equity is the same amount. If you want to find out what your usable margin is the formula is simple: Usable Margin= Equity – Used Margin.
Get one thing straight. It’s your equity, that used to determine the usable margin. It’s definitely not your balance. The size of your equity will also determine when the margin call alarm goes off. So long as your equity is greater than your used margin,you wont get that margin call from your broker. And when you do get that margin call,you’d be better off going back to your demo account and re-learn all your price action strategies. Jumping back into the market will cause you a major nervous breakdown.
That’s a wrap for ”The Double Edged Sword Called Leverage and Margin .” Leverage and margin look enticing.But they can suck you dry if you get too greedy. So when you calculating your leverage and margin, make sure you don’t cut your nose to spite your face.
Til next time take care.
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