Many traders choose Forex market because of possibility of using leverage. The most popular leverage on Forex market is 1:100. What does it mean to the trader? It means that he can control position 100x higher than his account deposit. Next thing we should now is an equity of our account.
Equity
In the beginning when we just opened broker account and we funded it with some money, it will be all our deposit which can be used to secure position. It is worth to notice that this money is not used only to secure position but also to cover potential losses. However many brokers offer bonuses to your funds, for example extra 20, 50 or even 100%. Although this money is viewed as credit it can increase our equity and let control bigger positions. I
We should take a look at difference between balance, equity and free margin:
- Balance – money we deposited on our account which is higher or lower in pair with our profits/losses.
- Equity – It contains balance, all positions opened and bonuses from the broker
- Free margin – amount left after adding profits/loss from opened position and deposit needed to secure it.
Let’s assume that we have 1000€ balance and 600€ credit. In total our equity is 1600€. This is how much we can use to secure our positions.
How big can be a position with this small amount of money? This is where leverage comes to help.
Leverage
Many traders and people starting their adventure with FX market see only advantages of leverage because they focus only on what they can earn. Before we start to count our potential profits, we should make sure how big will be loss in case of movement in opposite direction than we assumed.
As it was already said in the beginning, leverage let us controlling position multiple times bigger than our balance. Looking at previous example, if we have 1000€ account and we got 600€ bonus from our broker, we have 1600€ to use as margin deposit. Thanks to 1:100 leverage we can control position worth:
1,600 * 100 = 160,000€
How does it look with trading on GBPUSD?
In our example account our deposit is in euro (EUR). We want to speculate for example on GBPUSD. It means that we will make spot buy or sell transaction of base currency using quoted currency. In case of GBPUSD base currency is GBP and quoted currency is USD.
If we want to check how big position on GBPUSD we can take with equity of 1600 € we have to count it:
- Deposit: 1000€
- Credit: 600€
- Free margin: 1600€
- Leverage: 1:100
- EURGBP price: 0.8520
(Free margin*leverage)/EURGBP = (1600*100)/0.8520 = 187,793.42 GBP
How much it will be in lots?
The basic position size on Forex market is a lot, which is 100,000 units of base currency. This is why we can control with our 187,793 GBP exactly 1.87 lots. Of course it is accurate only to standard accounts. There are also accounts using micro lots, where 1 micro lot is 1000 units of base currency. In this case our position will have 187.79 micro lots.
These calculations should serve only as an example and leverage should serve us, not harm. It is not rational to use all our money to put in one position at once using maximum of our leverage. This kind of activity in case of unfavourable movement would quick bring us to critical level – stop out – in which broker can close our positions (and would certainly do that) because of lack of money needed to secure it. None of us would like to end with trading like this.
Unless…
Lately quite popular is a method of money management where we put on broker account only small part of our investment capital (for example 10%) and using leverage that we will use in opened positions 50% of balance.
Let’s assume our investment capital is 10,000€. We pay 1,000€ to broker account. For secure of positions we give 50% of that money, which is 500€.
In this situation and according to equation given earlier the biggest position on EURGBP would be:
500 EUR (deposit) *100 (leverage) / 0.8520 (EURGBP price) = 58,685.44 GBP which is 0.58 lot or 58.68 micro lot.
Pip value
We know how big position we can open on EURGBP with deposit of 1000€ but how much we will earn or lose with one pip of change? To know that we have to count how much will be our pip worth for position of 0.58 lot:
(0.58 lot * 0.0001) * EURUSD price = (58,000 * 0.0001) * 1.0450 = 6.061 EUR
For the position of 0.58 lot every pip change in direction assumed by us will give us 6.06 EUR of profit and every pip change opposite will be that big loss.
The same way you can count your spread when opening position, this is your transaction cost paid to the broker for opening position.
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Conclusion
In the Internet you can find many calculators which will calculate these things for us but if we want to stay on the Forex market for longer, we should know at least basic methods. Thanks to that we will be more aware of our transactions. You have to remember that if you have account in one currency and you want to trade on some other currency pairs, you have to do one more transaction connected with exchanging EUR for example for GBP.
In the end I would like to encourage you to use leverage carefully. Many bad things about Forex market is said because of leverage, but it is not bad itself. Only in wrong hands it can become bad thing. It is like with a knife which is a great tool and it helps millions of people every day. Unfortunately it happens that someone use it to harm himself or other people. It does not mean that knives itself are bad tools.
