Currency is traded in lot sizes ranging from 100- to 100,000-unit lots on the
retail spot market. Remember that a unit of currency could be a dollar,
euro, pound, or whatever your account denomination. By trading multiple
lots, a currency trader can hold a position of virtually any size, provided
that she has the capital to match it unit for unit. Of course, investing in a
single 100,000 lot is not practical for most retail traders, and even if you
could, why would you? It would be an extremely inefficient use of capital
to tie up 100,000 units in one standard currency lot.
Currency is typically traded through a margin account, which allows
you to control a position much larger than the capital you have in your
account. Margin and leverage are important tools that are, unfortunately,
misunderstood by many traders. In this section we discuss what margin is,
how leverage works, and how leverage affects risk.
What Is Margin?
Margin is represented by the percentage of capital required to maintain
an open currency position with your currency dealer. The margin amount
represents a good-faith deposit to the dealer that you are creditworthy for
the full amount of the position you are trading. Many traders believe margin
is actually part of the currency you are trading, but it is not. Your currency
dealer loans you the full position size in return for your good-faith deposit,
represented by the margin amount. The percentage is usually fixed across
many currency pairs, although some illiquid or exotic currencies may have
higher margin requirements. If your currency dealer requires a 1 percent
margin and you open a 100,000-unit trade, your margin requirement to keep
this position open is 1,000 units of currency in your account.
If your account balance falls below the required margin amount, your
currency dealer will usually liquidate all open positions to avoid further
losses. This process is known as a margin call. Although margin calls are
painful, they actually protect you from owing the dealer money on a position
that has gone bad. Without automatic margin calls, your account could
fall into a negative balance and you would owe the dealer money to cover
his losses. Talk about pouring salt in the wound! Maintaining an account
balance large enough to manage normal market losses without approaching
your margin requirements is a crucial step in money management. Most
currency trading platforms will calculate your usable margin and used margin
in real time to ensure that you always know where your account stands
in relation to the margin requirements on open trades.
What Is Leverage?
Leverage is simply a function of the margin you are required to maintain for
each trade. Leverage is measured in a ratio format such as 100:1 or 25:1. For
example, if your margin requirement is 1 percent on a $10,000 trade, you
must maintain at least $100 in your account to keep that position open.
This represents 100:1 leverage because you control $100 for every $1 in
your trading account. Some dealers advertise that they allow leverage as
high as 700:1; however, using that amount of leverage on every trade might
not be suitable for all traders.
Table 1.6 illustrates how leverage and margin work together. Assuming
that a trader buys one standard currency lot worth $100,000, the leverage
amount varies depending on the trader’s margin requirement. As margin
requirements are increased, leverage is decreased.
The Effects of Margin and Leverage on Risk
Margin and leverage affect risk in different ways. Margin requirements
climb as you accumulate open positions, which could leave your account
at risk for a margin call, even when the individual positions are small. This
is a death-by-1,000-cuts scenario because you have over leveraged your account
with small trades to the point that there is no room between margin
requirements and your account balance.
Table 1.7 illustrates how fast a trader with a small account can get
herself into trouble by opening too many positions. The trader with $500
who opened four $10,000 positions left herself with only $100 to absorb any
market losses that occur during the life of that trade. You must understand
how much margin will be consumed by a trade before you open it or you
could find yourself without sufficient usable capital to maintain it before a
margin call occurs.
Smaller accounts should consider using no more than 100:1 leverage,
whereas conservative trades may consider raising their margin requirements
to bring leverage down to 25:1 or 10:1. Understanding how margin
and leverage will affect your positions is crucial to surviving as a currency
trader. Opening too many trades or using too much leverage with large
trade sizes is sure to wipe out your trading account before winning trades
can grow it.