 # Understanding pips, lots, position size

Beginner
AvramisDespotis 3 Lessons 6 Hours

# Understanding Leverage and Margin

Welcome to Understanding Leverage and Margin! In this video, you will learn about cash accounts, margin accounts, leverage, margins, and margin calls.

Cash Accounts

In a cash account, the maximum buying power is equal to the capital invested. In other words, with a \$10,000 deposit, one can buy shares or currencies up to \$10,000 and not more. In a margin account, traders can take advantage of leverage to trade bigger positions than the value of their deposit. With a \$10,000 deposit, one can buy shares or currencies equivalent to \$100,000 or more.

Leverage

Leverage is a loan that is provided by the broker to the investor that enables the investor to trade a bigger amount than the initial balance. The ratio can be 2:1, 3:1, 10:1, up to 500:1. If you deposit \$10,000 in your trading account and you choose to trade with a leverage of 100:1, you can trade up to 100 times \$10,000 which equals to \$1,000,000. In other words, the leverage provides the means to an investor to have increased trading capital, giving the opportunity of having maximized outcome.

Let us go over two scenarios and illustrate how leverage works.

In the first scenario let us suppose we made an initial deposit of €10,000 with a leverage choice of 100:1. This gives us a trading capital of €1,000,000. If we buy 1,000,000 EUR/USD at the price of 1.1300 and sell 1,000,000 EUR/USD to close the position at 1.1400, we will make a profit of 100 pips or \$10,000. This means we almost doubled our money.

In the second scenario, with an initial deposit of €10,000 with a leverage choice of 100:1, this gives us again a trading capital of €1,000,000. Again, we buy EUR/USD at 1.1300 but this time, the price goes down and we sell to close our position at 1.1280. We lost 20 pips on this position or \$2,000. We lost almost 20% of our investment.

Margins

Since a trader is allowed to use more capital than the initial amount deposited due to leverage, a collateral in the form of margin is required by the broker to ensure that all losses are covered. For an account balance of \$20,000 and a leverage choice of 20:1, the required margin for the open position is 1 divided by the leverage level of 20 which is equal to 5%. If the leverage choice is 100:1, the required margin is 1 divided by the leverage level of 100, which is equal to 1%. Margin is the value of open positions multiplied by the margin percentage, so for a margin of 1% and a position of \$200,000, the margin will be \$2,000. As you can notice, margin is directly linked to the leverage level of the account.

Free Margin and Margin Level

For an account with an initial balance of \$20,000 and a required margin of 1%, we take a position of \$1,000,000. The open price is 1.1300 and at the time of the open, the profit is 0. The account balance is \$20,000 and the required margin is \$10,000. The free margin is the account balance of \$20,000 minus the required margin of \$10,000 which is equal to \$10,000, meaning you have \$10,000 available to open new positions.

In percentage terms, your margin level is the account balance of \$20,000 divided by the required margin of \$10,000 that is 200%.

 Initial balance \$20,000; required margin 1% Position size \$1,000,000 Open price 1.1300 Profit \$0 Account balance \$20,000 Required margin (in \$) \$1,000,000 x 1% = \$10,000 Free margin \$20,000 - \$10,000 = \$10,000 Margin level (20,000 / 10,000) x 100 = 200%

If the price of your investment dropped from 1.1300 to 1.1200, the loss would be \$10,000. The new account balance is \$20,000 initial deposit minus \$10,000 loss, amounting to \$10,000. The required margin is the same as before at \$10,000. Free margin is now the new account balance of \$10,000 minus the required margin of \$10,000 for the open positions which is equal to \$0, meaning you do not have any more free margin to open any new positions. In percentage terms, your margin level is now the account balance of \$10,000 divided by the required margin of \$10,000 which equals 100%. When your margin level reaches 100%, you don’t have any free margin to open any new position. This is the danger zone.

 Initial balance \$20,000; required margin 1% Position size \$1,000,000 Open price 1.1200 Profit -\$10,000 Account balance \$10,000 Required margin (in \$) \$1,000,000 x 1% = \$10,000 Free margin \$10,000 - \$10,000 = \$0 Margin level (10,000 / 10,000) x 100 = 100%

Margin Call and Stop Out

Two words that traders don’t want to hear is margin call. When your margin level drops to 50%, you will enter the margin call territory where you should deposit more money or alternatively start closing some of your open positions in order to meet your margin requirements and return your margin level to 100%. You can think of it as a warning call.

If your position keeps losing and your margin level drops to 20%, your account will be stopped out automatically by the broker and positions will be closed to return the margin level to 100%. This way, both the broker and the investor will be protected. It prevents the loss of more money than initially deposited into the account in normal market conditions.

Recap!

 Cash account An account wherein maximum buying power is equal to the capital invested. Leverage A loan that is provided by the broker to the investor that enables the investor to trade a bigger amount than the initial balance Margin Collateral required by the broker to ensure all losses are covered. Margin level The percentage value of the account balance divided by required margin. Free margin The sum of account balance minus required margin (in currency value). Margin call A warning for the investor to deposit more money or to start closing open positions to meet margin requirements. Stop out Similar to a margin call, a stop out happens when an investor’s losing position is automatically closed by the broker to return the margin level back to 100%.

In the next video, we will talk about Liquidity, Slippage and Swaps. Thank you for watching!