Margin and Leverage
Lots and Position Sizes
Currencies are traded in units of currencies which are grouped in lots. At a retail level, lots are divided into several categories: the so-called "full-size" or "standard" lots, "mini" lots, and "micro" lots.
A standard lot consists of 100,000 units of whatever the base currency in the currency pair is. A mini lot consists of 10,000 units of the base currency and a micro lot 1,000 units of the base currency. As you can see, a mini contract is one-tenth the size of a standard contract and the micro lot one-tenth of the mini lot.
So for instance, when buying one micro lot on the GBP/USD, you would buy 1,000 British pounds and sell an equivalent amount of US Dollars.
Let's suppose the current exchange rate for GBPUSD is 2.4500 and you want to buy 10,000 US Dollars worth of this pair. Here's the math:
For pairs with USD as the quote currency, take the dollar amount you want to purchase and divide it by the exchange rate:
(desired position size) / (current rate) = # of units
100,000 US Dollars / 2.4500 = 40,816.32 units of GBPUSD
As you can see, this is approximately 4 mini lots of British Pounds rounded down.
Buying a pair with USD as the base currency is much easier to calculate. Why? Because in these cases you just buy the amount of units you want because you are purchasing US dollars, the base currency.
And in the case of a cross pair transaction, when buying 100,000 US dollar worth of GBPCHF, for instance, we purchase 40,816.32 units of GBPUSD at the above rate and sell 100,000 units of USDCHF.
Being able to choose among several lot sizes is a huge advantage retail Forex trading offers to the small investor. It allows you to tailor and fine tune your money management to better meet your trading style.
If you have a small account size keep your risk profile low by choosing to trade with mini lots. Even many seasoned traders avoid standard contracts to be more precise in their position sizing.
FAQ Box - Can I still trade currencies if the lot sizes are much superior to my account size? Yes. And not only that: by trading whatever size of lots you will gain or lose profits as though that money was in your account. Making use of the leverage effect permits a trader to control a large amount of capital with a comparatively small amount of capital. This is called margin trading.
Nevertheless, margin trading is a double-edged sword: it can lead to large gains but conversely it can cause large losses if the exchange rate moves against the anticipated direction.
When conducting a Forex transaction, you are not actually buying all that currency and depositing it into your account. Technically, you are speculating on the exchange rate and contracting with your broker-dealer that they will pay you, or you will pay them, depending if the exchange rate moves in your favor or not.
A trader who purchases a USD/JPY standard lot does not have to put down the full value of the trade (100,000 USD). But to gear up the trade size to institutional level, the buyer is required to put down a deposit known as "margin". The minimum deposit capital varies from broker to broker and can range from $100 to $100,000.
That is why margin trading can be seen as trading with borrowed capital– it's basically a loan from the broker-dealer to the trader, but based on the trader’s deposited amount. Margin trading is what allows leverage.
In the above example, the trader's initial deposit serves as a guarantee (a collateral) for the leveraged amount of 100,000 USD. This mechanism insures the broker-dealer against potential losses. As you see, you are not using the deposit as a payment or purchase of currency units. It is rather a good-faith deposit, made by the trader to the dealer or broker.
When executing a new trade, a certain percentage of the deposit in the margin account will be frozen as the initial margin requirement for the new trade. The quantity of required margin per trade depends on the underlying currency pair, its current exchange rate and the number of lots traded. Remember, the lot size always refers to the base currency. The frozen initial margin requirement may not be used in trading until the trade is closed.
The more positions are opened simultaneously the more margin is required until it eventually becomes a notable percentage of your account.
Margin Call - a Guaranteed Limited Risk
In the futures market, a losing position may go beyond the deposited margin, and the trader will be liable for any resulting deficit in the account. In Forex this will not happen as the risk is minimized through the mechanism of a "margin call".
Most online trading platforms have the capability of automatically generating a margin call when your margin deposits have fallen below the required minimum level because an open position has moved against you.
In other words, when the losses exceed the deposit margin, all open positions will be closed immediately, regardless of the size of positions held within the account.
A very extended and poor definition of leverage is that it's a tool that will help traders earn money fast and easy. And indeed, one of the most important advantages of the Forex market is given by the effect of leverage! Without leverage, it would be very difficult to accumulate capital by trading the market, especially for small investors. But leverage can also be very harmful if not properly understood. This duality is what makes this concept difficult to grasp and explains partly why there are so many misconceptions about it.
Financial leverage, meaning a purchase on a margin, is the only way for small investors to participate in a market that was originally designed only for banks and financial institutions. Leverage is a necessary feature in the Forex market not only because of the magnitude of capital required to participate in it, but also because the major currencies fluctuate on average less than 2% per day.
Trading currencies on margin lets you increase your buying power. Suppose you trade with $5,000 in margin and you purchase 5 standard lots worth of 500,000 currency units, that’s a 100:1 leverage, because you only have to post one percent of the purchase price as collateral.
This means the trader has to have at least $5,000 in the margin account to control 5 full size lots.
Alert Box – This is the reason why the rollover amount depends on the size of the transaction: with higher leverages, the interest differential the broker-dealer pays or charges will proportionally increase, because you are controlling a larger amount of currency, even if you don't have that amount in your account.
The normal margin requirement is between 0.2% and 2% of the underlying value of the trade, that is a leverage between 50:1 and 500:1. The account types Swissquote offers have their margin requirements scaled, which allows smaller accounts to use higher leverages like 200:1, and bigger accounts to use 50:1.
A common way to calculate the margin required per trade is the following: suppose you are allowed a 100:1 maximum leverage as per your account type. The maximum trade size is then calculated as amount in USD x 100. Supposing you decide to buy one standard lot of GBP/USD. To figure out the amount of capital which has to be set aside as margin for the value of the deal, we need to take the current rate for GBP/USD (let's say 2.0200) and do the following:
(2.0200 * 100,000)/100 = $2020.00
Should the account balance equal or drop below the margin requirement, the broker-dealer would liquidate all open positions on a margin call. That means that using $2020 in margin and trading one standard lot with $10,000 in the account, if the trade would go negative by $7981, a margin call would occur.
IF (margin account) – (position value) < min. margin requirement
$10,000 – $7,981 = $2,019 < $2,020 → margin call!
In reverse quote pairs, the currency denomination for the leverage is already in USD. In the case you would decide to buy a standard lot of USD/JPY at a rate of 105.00, then you would need a $1,000 margin for a $100,000 lot with a 100:1 leverage.
Let's say you have an account with $10,000 and you open that USD/JPY position. The broker won’t automatically close the trade if the losses exceed $1,000. The margin call will occur only when your net balance is less than $1,000. So if the position goes against you and accumulates $9,001 worth of losses, your position will be automatically closed and you will be left with $999 in your account.
Broker platforms already include the spread and the rollover into the equation, but remember that these variables also influence the net balance.