Forex Investment and Currency Trading

Leverage is the size of a market position you can control based on your available margin collateral. If the leverage ratio is 10:1, and you have $1,000 of available margin, you’re able to hold a position equivalent to $10,000.

Online currency trading firms typically offer higher leverage ratios than you may be familiar with from trading stocks on margin. Leverage ratios among currency brokers are typically on the order of 100:1 for standard-size accounts (100,000 trade-lot size) and 200:1 for mini-accounts (10,000 trade-lot size).

Leverage is a great trading tool, allowing traders with less capital to participate in markets that they couldn’t trade otherwise. But leverage is still just a tool. As with any other tool (think of a chainsaw here), if you learn how to use it properly, you’ll be able to get the job done. But if you don’t learn how it works, you’re asking for trouble.

Most people see only the upside benefits of leverage – the larger the position on a profitable trade, the more profit you get. Yes, leverage will magnify your gains, but it’ll also magnify your losses – the larger the position on a losing trade, the larger the loss you’ll experience. You need to have a healthy respect for the downside risk in trading, or you won’t last very long.

Take an example of 100,000 lot-size account with $5,000 in initial margin deposited at a 100:1 leverage ratio. That margin balance translates into a maximum position size of $500,000. If you were to take a position in USD/JPY at 100.00 using the maximum amount of leverage, every pip change in USD/JPY is worth about $50 [($500,000 x 0.01 pips)/100.00 = $50.00]. But USD/JPY is regularly subject to 50- to 100-pip price swings in a single day (or more). If you’re positioned the wrong way, you could lose $2,000 to $4,000 in the course of a normal, run-of-the-mill trading day. That’s 40 percent to 80 percent of your trading capital in just one trade!

The key here is to avoid being seduced by leverage. Just because you’re able to get 100:1 leverage doesn’t mean you have to use it all. Trading a larger position may seem sexy, but no one ever said prudent, risk-aware trading was supposed to be sexy. Use leverage as a tool to facilitate your trading strategies, not as an ego booster.

Knowing your margin requirements

Online forex brokers require margin posted as collateral to cover any losses on your trading account. To protect themselves from client losses eating up the entire margin (or going negative) in adverse market movements, online brokers typically require a minimum available margin balance for any open positions.

For example, if the minimum available margin requirement is 50 percent, it means you must have as available margin at least 50 percent of the required margin for that position. At 100:1 leverage, if you’re holding a $100,000 position in USD/CHF, you’ll need to have at least $500 of available margin to continue to hold the position ([$100,000 / 100] x 0.50 = $500). If your available margin balance falls below $50 at any time, even for a second or a pip, your broker has the right to liquidate your position, which is a fancy way of saying it closes out your position for you. Your losses are locked in, and your available margin balance is reduced.

Margin balances are typically monitored by computer programs based on currency market prices. If a price move causes your available margin to fall below the required level, the position will be closed – no margin call, no notification to you, just a liquidated position. You may think that’s unfair, but the reality is that brokers need to liquidate losing positions at some point, or your loss will become theirs.

As a trader, it’s your responsibility to read the find print and to know the minimum margin requirements and liquidation policies before you start trading. Regulated forex brokers must disclose their policies in your customer account agreement.

Minimum margin requirements vary form broker to broker and by account size (standard versus mini, for example). Broker liquidation policies can also vary, with some closing all open positions at once (in the case of multiple open positions) and others closing the largest losing position first until the minimum requirement is met for remaining open positions.

From a trader’s perspective, you never want to be in the situation where your positions are liquidated due to insufficient margin. It means you’re trading too large a position for your available margin or you’ve left the losses run for too long relative to your available margin. Each trade plan needs to factor in the minimum margin requirement, and it should never even come close, or you’re better off looking for another trade opportunity with lower risk.