Understanding Lots, Leverage, and Margin

Lots, leverage and margin are not the most exciting topics we are going to cover. However, if you want to become a Forex trader, it is vital that you understand lots, leverage, and margin. There is an exception to this – UK residents have the option to spread bet, which works differently. If you are spread betting, you can skips this article if you like, but I still recommend reading on!

What is a Lot in Forex?

In the previous article we went over what a pip is and how to calculate the value of a pip. We got an extremely low pip value, an example being USD/CHF where one pip was worth $0.00009250.

So, $0.00009250 is the value of a pip per unit and the standard size of a lot is 100,000 units of the base currency.You need to buy or sell one or more lots to open a trade. Let’s say you open a long trade with one standard lot on USD/CHF and buy 100,000 units. We know one pip per unit is $0.00009250 so all we need to do is multiply! $0.00009250 X 100,000 = $9.25 USD.

$9.25 per pip may sound like quite a lot. Don’t worry, 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 great for trading Forex without risking too much money. You don’t want to be trading standard lots when you first start out trading. If each pip is worth $9 and you lose a 100 pip trade, that is $900 down the drain. You can learn to trade without risking your life savings.

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. Each pip will be worth $0.9998 USD. Calculating how much you will make per pip on a trade is straightforward.

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 you want the pip value in USD but it is not the base currency, the formula looks 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 though. Why would you want to invest $10,000 and earn only $1 per pip? Well, that is where leverage comes into play.

What is Leverage?

Leverage is what allows you to trade more units than you have.

Imagine you have a mini account with a balance of $1,000 (1,000 units). You enter a trade with $100, and your broker is providing 100:1 leverage. That means you can hold a position up to $10,000 because for every $1 you put in, your broker will put in $99 to make it $100.

The important thing to remember about leverage is that it does not affect the value of a lot. A mini lot is always 10,000 units and a standard lot is always 100,000 units. If you have 400:1 leverage a mini-lot is roughly $1 a pip. With 100:1 leverage, a mini-lot is also roughly $1 a pip.

Leverage has an effect on the number of lots you can have in the market, based on the capital in your account.

The reason we call it leverage is because it is similar to lifting a very heavy object. Some things are just too heavy to lift. But if you get the right leverage, it is easy. Think of a see-saw!

If you have 100:1 leverage, you can trade a mini lot (10,000 units of currency) with just 100 units of your own.

leverage in forex

Leverage may sound great but it can also cause problems. The higher your leverage, the more capital you can risk at one time as opposed to having a lower leverage.

Let’s look at two traders who have the same capital, $10,000 USD. Trader A has 400:1 leverage and Trader B has 100:1 leverage. Trader A can risk much more of their $10,000 at one time than Trader B. It also means that Trader A can have less in their account to cover their position.

How about some more detail. Trader A takes a long position at 400:1 leverage and buys 1 mini lot (10,000 units). Trader B takes the same long position at 100:1 leverage and buys 1 mini lot also.

Since Trader B has 100:1 leverage, he is required to have 100/1 or 1% of that position in their account. So that means at least $100 in their account since $100 is 1% of 10,000 (1 mini lot). Trader A has 400:1 leverage so is required to have 400/1 or 0.25% of that position in their account. Trader A needs to have at least $25 in their account which is 0.25% of 10,000 (1 mini lot).

Leverage can be extremely dangerous. If you have a $1,000 account with 400:1 leverage, for just $100 you could trade four mini lots. If you take a 100 pip loss on that trade, you lose $400 which is 40% of your account!

In the end though, you are the one that determines the degree of your leverage. Your broker can offer a maximum leverage, but whether you use that maximum is up to you

What is Margin?

Margin is a good faith deposit required by your broker to cover the position you have entered into the market. Without providing a margin you won’t be able to use leverage. This is because your broker uses this to maintain your position and cover any potential losses.

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

Each currency pair moves differently, so that is a factor in how much margin is required. You’ll tend to find the more volatile pairs move more in a day. This means the margin required to trade those currencies is likely to be higher.

Margin is normally quoted in percentage terms, such as 0.25%, 0.50%, or 1%. This tends to increase as leverage decrease

The simplest way to think of margin is that it represents the 1 in the leverage ratio. So if your leverage is 100:1, your margin is the amount needed in your account (represented by the 1). This means that if you have a mini account and place a $10,000 position in the market, you will need $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 will close out any open 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 currently being used in open trades. If you have $6,000 capital in your account and have $1,000 in an open trade, your used margin is $1,000. If you have $3,000 capital in your account and have $600 in an open trade, your used margin is $600. Simple!

Usable Margin: The amount of money in your account minus any open trade. Using the same examples, if you have $6,000 capital in your account and have $1,000 in an open trade, your usable margin is $5,000. With $3,000 capital in your account and $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.

After analyzing GBP/USD, Tom decide the pair is going up. He opens a long position with 2 standard lots on GBP/USD. That means Tom is trading $2,000

Disaster strikes! GBP/USD goes down instead of up nad Tom curses himself for taking a long. 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 drop by too many pips and Tom’s usable 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. After analyzing EUR/USD, she decides to short and enters 7 mini lots ($700). Before entering the positions, Mary’s usable margin was $1,000. Now that she is in the trade her usable margin is $300.

Once again, disaster has struck and Mary’s trade goes against her. If Mary’s usable margin reaches $0 her trade is automatically closed to prevent her from losing more money than she has in the account.

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

It is vital that you check what the margin policies are with you broker. Policies can differ from broker to broker so if you plan on opening an account, remember to ask!