# The Term "LEVERAGE" Leverage Defined

The textbook definition of “leverage” is having the ability to*control*a large amount of money using none or very little of your

*own*money and

*borrowing*the rest.

For example, in forex, you can control $100,000 with a $1,000 deposit. Your leverage, which is expressed in ratios, is now 100:1. You’re now controlling $100,000 with $1,000.

Let’s say the $100,000 investment rises in value to $101,000 or $1,000. If you had to come up with the entire $100,000 capital yourself, your return would be a puny 1% ($1,000 gain / $100,000 initial investment). This is also called 1:1 leverage. Of course, I think 1:1 leverage is a misnomer because if you have to come up with the entire amount you’re trying to control, where is the leverage in that?

Fortunately, you’re not leveraged 1:1, you’re leveraged 100:1. You only had to come up with $1,000 of your money, so your return is a groovy 100% ($1,000 gain / $1,000 initial investment).

# Margin Call Example

Assume you are a successful retired British spy who now spends his time trading currencies. You open a mini account and deposit $10,000. When you first login, you will see the 10,000 in the "Equity" column of your "Account Information" window.#### Usable Margin

You will also see that the "UsedMrg" ('Used Margin') is "$0.00", and that the "UsblMrg" ('Usable Margin') is 10,000, as pictured below:Your Usable Margin will always be equal to Equity less Used Margin.

Usable Margin = Equity – Used Margin

Therefore it is the Equity, NOT the Balance that is used to determine Usable Margin. Your Equity will also determine if and when a Margin Call is reached.

As long as your Equity is greater than your Used Margin, you will not have Margin Call.

( Equity > Used Margin ) = NO MARGIN CALL

As soon as your Equity equals or falls below your Used Margin, you will receive a margin call.

( Equity =< Used Margin ) = MARGIN CALL, go back to demo trading

Let’s assume your margin requirement is 1%. You buy 1 lot of EUR/USD.

Your Equity remains $10,000. Used Margin is now $100, because the margin required in a mini account is $100 per lot. Usable Margin is now $9,900.

If you were to close out that 1 lot of EUR/USD (by selling it back) at the same price at which you bought it, your Used Margin would go back to $0.00 and your Usable Margin would go back to $10,000. Your Equity would remain unchanged at 10,000.

But instead of closing the 1 lot, you, the adrenalin junkie chopsocky retired spy that you are, get extremely confident and buy 79 more lots of EUR/USD for a total of 80 lots of EUR/USD. You will still have the same Equity, but your Used Margin will be $8,000 (80 lots at $100 margin per lot). And your Usable Margin will now only be $2,000, as shown below:

With this insanely risky position on, you will make a ridiculously large profit if EUR/USD rises. But this example does not end with such a fairy tale.

The EUR/USD starts to fall. You are long 80 lots, so you will see your Equity fall along with it. Your Used Margin will remain at $8,000. Once your equity drops below $8,000, you will have a Margin Call. This means that some or all of your 80 lot position will immediately be closed at the current market price.

Assuming you bought all 80 lots at the same price, a Margin Call will trigger if your trade moves 25 pips against you.

25 PIPS!

Humbug! The EUR/USD pair can move that much in its sleep!

How did I come up with 25 pips? Well each pip in a mini account is worth $1 and you have a position open consisting of 80 freakin’ lots. So…

$1/pip X 80 lots = $80/pip

If EUR/USD goes up 1 pip, your equity increases by $80.

If EUR/USD goes down 1 pip, your equity decreases by $80.

$2,000 Usable Margin divided by $80/pip = 25 pips

Let’s say you bought 80 lots of EUR/USD at $1.2000. This is how your account will look if it EUR/USD drops to $1.1975 or -25 pips.

As you can see, your Usable Margin is now at $0.00 and you will receive a MARGIN CALL!

Of course, you’re a veteran international spy, you’ve faced much bigger calamities. You’ve got ice in your veins and your heart rate is still 55 bpm.

After the margin call this is how your account will look:

The EUR/USD moves 25 PIPS, or less than .22% ((1.2000 – 1.1975) / 1.2000) X 100% and you LOSE $2,000!

You blew 20% of your trading account! (($2,000 loss / $10,000 balance)) X 100%

In reality, it’s normal for EUR/USD to move 25 pips in a couple seconds during a major economic data release.

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**Oh I almost forget…I didn’t even factor in the SPREAD!**

To simplify the example, I didn’t even factor in the spread, but I will now to make this example super realistic. Let’s say the spread for EUR/USD is 3 pips. This means that EUR/USD really only has to move

*22*pips,

*NOT**25*pips before a margin call.

Imagine losing $2,000 in 5 seconds?!

This is what happened to our popular British spy all because he didn’t understand the mechanics of margin and how to use leverage.

The sad fact is….most new traders don’t even open a mini account with $10,000. Because our spy friend had at least $10,000, he was at least able to weather 25 pips before his margin call.

If he only started off with $9,000, he could only weather a 10 pip drop (including spread) before receiving a margin call. 10 pips!

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