Making Leverage Easier to Understand

Leverage gives traders the ability to open positions with trade sizes larger than their account equity. We want to be careful when using leverage as this magnifies both our trades’ gains and losses, but how can leverage be controlled? How do we determine the amount of leverage we are using at any given time? These are the questions we will cover in today’s article.

Learn Forex: Minimum Margin Requirement (MMR)

(Created using FXCM’s Trading Station Desktop)

Margin Can Be a Distraction

In the image above, we are looking at the FXCM Trading Station’s Dealing Rates window with a focus on the column labeled “MMR.” This shows us the minimum amount of money required to open a 1k microlot trade on each pair (at the time this screenshot was taken). So for example, if we were to open up a 1k trade on the USD/JPY, it would require $20 to be set aside from my account’s equity. If we wanted to open a 10k trade, that would take $200 to be set aside. A 100k trade would require $2,000 set aside, etc.

At this exact moment is where many traders begin to look at leverage the wrong way. We see the margin required, we look at our account’s equity level and then figure out how much we can open. So a trader with a $2,500 account might feel comfortable opening a 100K USDJPY position because it only requires $2,000, but that would be a terrible decision. Why? Because we would be leveraging our account 40 times!

How We Should Calculate Leverage

So where did we go wrong with our trade? We were so distracted by the margin requirement that we forgot to look at what we were actually trading, $100,000 US Dollars against the Japanese Yen. $100,000 is 40 times our $2,500 equity that we deposited into our trading account. Using this amount of leverage is very dangerous and actually decreases the chance we will be profitable traders in the long run.

To solve this problem, we need to first look at the actual trade size in relationship to how much equity we have in our account. We need to calculate what each trade’s notional value is and make sure it is not too large for our risk appetite. A good rule of thumb that I follow is never trade more than 10 times your account’s equity across all of your open trades.

For example, our $2,500 account… we would multiply $2,500 by 10 to get to $25,000. That means we could open up a maximum of 25k USD/JPY and be within the rule of 10. The best part is, as long as we always keep our trades less than 10 times our equity, we don’t need to worry about how much margin each pair requires. The formula insures our account will be well capitalized for the positions we have open.

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—Written by Rob Pasche

To contact Rob, email rob@dailyfx.com.

Making Leverage Easier to Understand