Many beginning traders don't fully understand the concept of leverage. Basically, if you have a start up capital of $5,000 and if you trade on a 1:50 margin you can effectively control a capital of $250,000. However, a two percent
move against you and your capital is completely wiped out. If you are a beginning trader you should not use more than 1:20 margin until you get comfortable and profitable and then and only then you can attempt to use higher margins.
What does 1:20 margin mean? It means that with your $5,000 you will control a capital of $100,000. Let's say you are trading EUR/USD and by using our entry strategy you have decided to enter the trade on a long side. That means that you are betting that USD will depreciate against Euro.
Let's say current EUR/USD rate is 1.305. Again, if your trading capital is $5,000 and you are using 1:20 leverage you will effectively be exchanging $100,000 to Euros. If the current rate is 1.305 you will receive 100,000/1.305 = 76,628 Euros.
If the trade goes in your direction margin will work in your favour and 1% decline in USD will mean 20% increase in your start up capital. So if EUR/USD rate moves from 1.305 to 1.318 you will be able to exchange your 76, 628 Euros back to $101,000 for a profit of $1,000. Since your start up capital was $5,000 it is effectively a 20% increase in your account. However, if the trade went against you and USD appreciated 1% vs. Euro your account would be reduced to $4,000. That would not have happened as our strategy has built in hard stops to prevent such outcome.
The most frequently asked question of aspiring traders is How much money can I make? Unfortunately there's no easy answer, because it depends how much you are willing to risk.
Trading is a function of risk and reward: The more you risk, the more you can make. Here's an easy example: Let's say you start with a $5,000 account and you're willing to risk $1,000. Now you could place a trade to go long at the opening, set a profit goal of $1,000 and a stop loss of $1,000. Let's say you investigated the market behavior in the past couple of months and realized that your chances of achieving your profit goal are 60%.
Unfortunately the trade you just placed is a loser, and you lose the whole $1,000. Since this was the amount you were wiling to risk, you close your account, transfer the remaining $4,000 back in to your checking account and that's it for you.
Now let's assume you wanted to risk only $100 per trade and you adjusted your profit goal to $100, too. Now you can make at least 10 trades, because only if all 10 trades are losers you'll lose the $1,000 you are willing to risk. I don't want to become too mathematical, but statistics says that the probability of having 10 losing trades in a row is less than 1%. Therefore it's highly likely that you will have a couple of winners within the 10 trades. If your trading system shows the same performance as it did in the past (60% winning percentage), you should make $200: 4 losing trades * $100 = -$400 + 6 winning trades * $100 = $600. Make sense?
Compare these two options:
The risk of losing your money in scenario 1 is 40%. But if you won, you would have made $1,000.
In scenario 2 the risk of losing your money after 10 trades is less than 1%, but you have a fair chance of making $200. Therefore you need to define first how much you are willing to risk, since the amount you can make is a function of that risk. Make sense? I'll give you more specific examples later in this chapter.
Keep in mind that there's a difference between the amount you need to trade and the amount you're willing to risk. Your broker is always asking your for a margin, and you need to fund your account with that margin requirement + your risk. In our previous example you funded your account with $5,000, but you only risked $1,000. More on that later.
50:1 Leverage: what does it mean?
With a minimum account of USD 10,000, for example, you can trade up to USD 500,000. The USD 10,000 is posted on margin as a guarantee for the future performance of your position.
The AUD/USD rate is quoted at '0.7500/04'. This quote represents the bid/offer spread for AUD vs USD. The offer rate of 0.7504 is the rate at which you can purchase AUD (or BUY AUD and SELL USD). The bid rate of 0.7500 is the rate at which you can Sell AUD to buy USD.
You believe that the Australian Dollar will strengthen against the US Dollar, and decide to BUY or 'go long' A$100,000 @ 0.7504 (the offer price).
Quote (bid/offer) 0.7500/04
Buy Price 0.7504
Initial Outlay (1% margin) A$1,000
In the example above you have purchased A$100,000. But because FX is traded on margin with CMC Markets you will only need A$1,000 (1%) to maintain the same market exposure.
The risk on this AUD/USD trade is equivalent to US$10 per each point movement. Each point is valued at 0.0001. For example if the AUD/USD rate moves from 0.7504 to 0.7505 you will receive a profit of US$10.
Your prediction is correct and the Australian Dollar appreciates against the US Dollar. The quote on AUD/USD is now 0.7590/94. To close your position, you decide to SELL A$100,000 @ 0.7590 (the bid price).
Quote (bid/offer) 0.7590/94
Sell Price 0.7590
Profit/Loss US$860 Profit
Your profit and loss is usually calculated in the secondary currency. Therefore the above AUD/USD trade profit/loss is calculated in US Dollars. With CMC Markets no brokerage or commission charges will be subtracted from your gross profit. You will only be charged a financing cost if you hold your position overnight.
Size of trade x (sell price - buy price) = profit & loss USD
100,000 x (0.7590 - 0.7504) = US$860 profit
Or, converting the US$860 back to A$ at a rate of 0.7590
(Profit/loss ? AUD rate) = profit & loss AUD
(860 ? 0.7590) = A$1,133.07 profit
By closing your position you realise a gross profit of A$1,133.07
If you anticipated incorrectly and sold AUD at 0.7500 and later bought AUD at 0.7594, a loss of US$940 would have been experienced.
If you want to buy/sell a specific amount of GBP, first enter the symbol GBP as the transaction currency. Then choose USD as the settlement currency from the drop down menu. You will then receive the quote USD/GBP, e.g. Bid: 1.5300 Ask: 1.5310
This means that GBP 1 = US$1.53XX
If you want to buy GBP 10,000, click on the ask and enter 10,000 as the quantity of GBP that you wish to buy. You will pay $1.5300 for each GBP. Thus, you will pay $15,310.
If you want to sell GBP 10,000, click on the bid and enter 10,000 as the quantity of GBP that you wish to sell. You will receive $1.5300 for each GBP. Thus, you will receive $15,300.
If you want to buy/sell a specific amount of USD. First enter the symbol USD as the transaction currency. Then choose GBP as the settlement currency from the drop down menu. You will then receive the quote GBP/USD, e.g. Bid: 0.6530 Ask: 0.6536
This means that USD 1 = GBP 0.653XX
If you want to buy USD 10,000, click on the ask and enter 10,000 as the quantity of USD that you wish to buy. You will pay GBP0.6536 for each USD. Thus, you will pay GBP 6,536.
If you want to sell USD 10,000, click on the bid and enter 10,000 as the quantity of USD that you wish to sell. You will receive GBP0.6530 for each USD. Thus, you will receive GBP 6,530.
You believe that signals in the market are indicating that the British Pound will go up against the US Dollar. You open 1 lot for buying the Pound with a 1% margin at the price of 1.49889 and wait for the exchange rate to climb. At some point in the future, your predictions come true and you decide to sell. You close the position at 1.5050 and earn 61 pips or about $405. Thus, on an initial capital investment of $1,000, you have made over 40% in profits. (Just as an example of how exchange rates change in the course of a day, an average daily change of the Euro (in Dollars) is about 70 to 100 pips.)
When you decide to close a position, the deposit sum that you originally made is returned to you and a calculation of your profits or losses is done. This profit or loss is then credited to your account.
Prices of foreign exchange are indicated by FOREX quotes in pairs of currencies. The first currency is the 'base' and the second is the 'quote' currency. In this example:
USD/EUR = 0.8419
...the currency pair is US dollars and European euros. The base currency (USD) is always at '1' and the quote currency shows how much it costs to buy one unit of the base currency. In this example, 1 US dollar costs 0.8419 euros.
EUR/USD = 1.1882
...tells us that it costs 1.1882 US dollars to buy 1 euro.
Example OCO Transaction:
Buy: 1 standard lot EUR/USD @ 1.3228 = $132,280
Pip Value: 1 pip = $10
This is an order to buy US dollars at 1.3328 and to sell them if they fall to 1.3203 (resulting in a loss of 25 pips or $250) or to sell them if they rise to 1.3328 (resulting in a profit of 100 pips or $1,000).
Here's another example:
The current bid/ask price for US dollars and Canadian dollars is
...meaning you can buy $1 US for 1.2152 CDN or sell 1.2157 CDN for $1 US.
If you think that the US dollar (USD) is undervalued against the Canadian dollar (CDN) you would buy USD (simultaneously selling CDN) and wait for the US dollar to rise.
This is the transaction:
Buy USD: 1 standard lot USD/CDN @ 1.2157 = $121,570 CDN
Pip Value: 1 pip = $10
Margin: $1,000 (1%)
You are buying US$100,000 and selling CDN$121,570. Your stop loss order will be executed if the dollar falls below 1.2147, in which case you will lose $100.
However, USD/CDN rises to 1.2192/87. You can now sell $1 US for 1.2192 CDN or sell 1.2187 CDN for $1 US.
Because you entered the transaction by buying US dollars (buying long), you must now sell US dollars and buy back CDN dollars to realize your profit.
You sell US$100,000 at the current USD/CDN rate of 1.2192, and receive 121,920 CDN for which you originally paid CDN$121,570. Your profit is $350 Canadian dollars or US$287.19 (350 divided by the current exchange rate of 1.2187).
The US dollar is normally considered the 'base' currency for Forex quotes. In the major pairs, this includes USD/JPY, USD/CHF and USD/CAD. For these currencies and many others, quotes are expressed as a unit of $1 USD per the second currency quoted in the pair. For example, a quote of USD/CAD 1.193 means that one U.S. dollar is equal to 1.193 Canadian dollars.
When the U.S. dollar is the base unit and a currency quote goes up, it means the dollar has appreciated in value and the other currency has weakened. If the USD/CAD quote increases to 1.231, the dollar is stronger because it will now buy more Canadian dollars than before.
The three exceptions to this rule are the British pound (GBP), the Australian dollar (AUD) and the Euro (EUR). In these cases, you might see a quote such as EUR/USD 1.3027, meaning that one Euro equal 1.3027 U.S. dollars.
The initial margin to enter into a forex currency pair at Terra Nova is 3%. For example, an account is funded with $100,000 USD. A Forex currency trader feels that the US dollar is undervalued compared to the Canadian dollar. To capitalize on this strategy, the trader buys US dollars and simultaneously sells Canadian dollars. The current bid/ask for USD/CAD is 1.1835/1.1843 (purchase $1 US for $1.1843 CAD or sell $1 US for $1.1835 CAD).
The available leverage is 100:3 or 3%. To purchase a one lot, this trader buys $100,000 USD and sells $118,430 CAD. Using the above leverage, the initial margin is $3000 ($100,000 x 3%).
Trading on margin means that you can buy and sell assets that represent more value than the capital in your account. Forex trading is usually done with relatively little margin since currency exchange rate fluctuations tend to be less than one or two percent on any given day. To take an example, a margin of 2.0% means you can trade up to $500,000 even though you only have $10,000 in your account.
In terms of leverage this corresponds to 50:1, because 50 times $10,000 is $500,000, or put another way, $10,000 is 2.0% of $500.000. Using this much leverage gives you the possibility to make profits very quickly, but there is also a greater risk of incurring large losses and even being completely wiped out. Therefore, it is inadvisable to maximise your leveraging as the risks can be very high.
A pip is the smallest unit by which a cross price quote changes. When trading forex you will often hear that there is a 5-pip spread when you trade the majors. This spread is revealed when you compare the bid and the ask price, for example EURUSD is quoted at a bid price of 0.9875 and an ask price of 0.9880. The difference is USD 0.0005, which is equal to 5 pips. On a contract or position, the value of a pip can easily be calculated. You know that the EURUSD is quoted with four decimals, so all you have to do is the cancel-out the four zeros on the amount you trade and you will have one pip. Thus, on a EURUSD 100,000 contract, one pip is USD 10. On a USDJPY 100,000 contract, one pip is equal to 1000 yen, because USDJPY is quoted with only two decimals.
A very common mistake made by novice forex traders is that they do not use a positive Risk/Reward ratio. By positive Risk/Reward ratio we mean the difference between the take-profit trade and the level of trade entry is greater than the difference between the stop-loss trade and the level of trade entry. In other words it means that you should not be willing to lose more than you want to make on a single trade.
Here is an example of a positive Risk/Reward ratio:
Buy EUR/USD 100,000 at 1.1500
T/P Sell EUR/USD 100,000 at 1.1600
S/L Sell EUR/USD 100,000 at 1.1440
In the above example the take-profit is 100 pips higher than the level at which the position was entered, and the stop-loss is 60 pips lower than the level at which the position was entered. The Risk/Reward ratio is 1:1.66.
Below is an example of a negative Risk/Reward ratio:
Buy USD/JPY 100,000 at 110.00
T/P Sell USD/JPY 100,000 at 110.30
S/L Sell USD/JPY 100,000 at 108.00
In the above example the take-profit is 30 pips higher than the level at which the position was entered, and the stop-loss is 200 pips lower than the level at which the position was entered. The Risk/Reward ratio is 1:0.15.
Below are examples of both a winning trade and losing trade when trading for a 10 pip profit or loss:
Buy EUR/USD at 1.2020 (price = 17/20)
Sell EUR/USD at 1.2030 (price = 30/33)
Market moves 13 pips before taking profit
Buy EUR/USD at 1.2020 (price = 17/20)
Sell EUR/USD at 1.2010 (price = 10/13)
Market moves 7 pips before taking loss
The above example highlights that the risk/reward of trading for a 10 pip profit or loss is very poor. For the same 10 pips P&L, the market must move 13 pips for your winning position, but only 7 pips for your losing position. For currency pairs quoted in 5-10 pip prices, obviously the risk/reward is even worse.
Here is an example of a reasonably profitable month for a successful trader. Let's imagine that his total capital is $20,000 and risk appetite per trade is 5%. This would mean he is willing to lose upto $1000 per trade. He always trades using a 100% Risk/Reward ratio (meaning that his stop-loss orders are the same distance as his profit-take orders, from the position entry level):
No. of Trades = 20
Winning Trades = 12
Losing Trades = 8
Total Profit = $4000
REO/month (Return on Equity) = 20%
The example shows that he got 60% of his trades right and made an REO of 20% for the month and he only risked 5% of his capital on every trade.
An investor has a margin deposit with Saxo Bank of USD100,000.
The investor expects the US dollar to rise against the Swiss franc and therefore decides to buy USD2,000,000 - his maximum possible exposure.
The dealer quotes him 1.5515-20. The investor buys USD at 1.5520.
Day 1: Buy USD2,000,000 vs CHF 1.5520 = Sell CHF3,104,000.
Four days later, the dollar has actually risen to CHF1.5745 and the investor decides to take his profit.
Upon his request, the Saxo Bank dealer quotes him 1.5745-50. The investor sells at 1.5745.
Day 5: Sell USD2,000,000 vs CHF 1.5745 = Buy CHF3,149,000.
As the dollar side of the transaction involves a credit and a debit of USD2,000,000, the investor's USD account will show no change. The CHF account will show a debit of CHF3,104,000 and a credit of CHF3,149,000. Due to the simplicity of the example and the short time horizon of the forex market trading, we have disregarded the interest forex rate swap that would marginally alter the profit calculation.
This results in a profit of CHF45,000 = approx. USD28,600 = 28.6% profit on the deposit of USD100,000.
The investor follows the cross forex rate between the Euro and the Japanese yen. He believes that this market is headed for a fall. As he is less confident of this forex market trading, he does not fully use the leverage available on his deposit. He chooses to ask the dealer for a quote in EUR1,000,000. This requires a margin of EUR1,000,000 x 5% = EUR50,000 = approx. USD52,500 (EUR/USD1.05).
The dealer quotes 112.05-10. The investor sells EUR at 112.05.
Day 1: Sell EUR1,000,000 vs JPY 112.05 = Buy JPY112,050,000.
He protects his position with a stop-loss order to buy back the euro at 112.60. Two days later, this stop is triggered as the euro strengthens short term in spite of the investor's expectations.
Day 3: Buy EUR1,000,000 vs JPY 112.60 = Sell JPY112,600,000.
The EUR side involves a credit and a debit of EUR1,000,000. Therefore, the EUR account shows no change. The JPY account is credited JPY112.05m and debited JPY112.6m for a loss of JPY0.55m. Due to the simplicity of the example and the short time horizon of the forex market trading, we have disregarded the interest forex rate swap that would marginally alter the loss calculation.
This results in a loss of JPY0.55m = approx.USD5,300 (USD/JPY 105) = 5.3% loss on the original deposit of USD100,000.
The investor believes the Canadian dollar will strengthen against the US dollar. It is a long term view, so he takes a small position to allow for wider swings in the forex rate:
He asks dealer for a quote in USD1,000,000 against the Canadian dollar. The dealer quotes 1.5390-95 and the investors sells USD at 1.5390. Selling USD is the equivalent of buying the Canadian dollar.
Day 1: Sell USD 1,000,000 vs CAD 1.5390. He swaps the position out for two months receiving a forward forex rate of CAD1.5357 = Buy CAD1,535,700 for Day 61 due to the interest forex rate differential.
After a month, the desired move has occurred. The investor buys back the US dollars at 1.4880. He has to swap the position forward for a month to match the original sale. The forward forex rate is agreed at 1.4865.
Day 31: Buy USD1,000,000 vs CAD 1.4865 = Sell CAD1,486,500 for Day 61.
Day 61: The two forex market trades are settled and the forex market trades go off the books. The profit secured on Day 31 can be used for margin purposes before Day 61.
The USD account receives a credit and debit of USD1,000,000 and shows no change on the account. The CAD account is credited CAD 1,535,700 and debited CAD 1,486,500 for a profit of CAD49,200 = approx. USD33,100 = profit of 33.1% on the original deposit of USD100,000.
Foreign currency exchange rates are what it costs to exchange one country's currency for another country's currency. For example, if you go to England on vacation, you will have to pay for your hotel, meals, admissions fees, souvenirs and other expenses in British pounds. Since your money is all in US dollars, you will have to use (sell) some of your dollars to buy British pounds.
Assume you go to your bank before you leave and buy $1,000 worth of British pounds. If you get 565.83 British pounds (Â£565.83) for your $1,000, each dollar is worth .56583 British pounds. This is the exchange rate for converting dollars to pounds.
If Â£565.83 isn't enough cash for your trip, you will have to exchange more US dollars for pounds while in England. Assume you buy another $1,000 worth of British pounds from a bank in England and get only Â£557.02 for your $1,000. The exchange rate for converting dollars to pounds has dropped from .56583 to .55702. This means that US dollars are worth less compared to the British pound than they were before you left on vacation.
Assume that you have ??100 left when you return home. You go to your bank and use the pounds to buy US dollars. If the bank gives you $179.31, each British pound is worth 1.7931 dollars. This is the exchange rate for converting pounds to dollars.
Theoretically, you can convert the exchange rate for buying a currency to the exchange rate for selling a currency, and vice versa, by dividing 1 by the known rate. For example, if the exchange rate for buying British pounds with US dollars is .56011, the exchange rate for buying US dollars with British pounds is 1.78536 (1 ?Â·.56011 = 1.78536). Similarly, if the exchange rate for buying US dollars with British pounds is 1.78536, the exchange rate for buying British pounds with US dollars is .56011 (1?Â·1.78536 = .56011). This is how newspapers often report currency exchange rates.
When you close out a trade, you can calculate your profits and losses using the following formula:
Price (exchange rate) when selling the base currency's price when buying the base currency X transaction size = profit or loss
Assume you buy Euros (EUR/USD) at 1.2178 and sell Euros at 1.2188. If the transaction size is 100,000 Euros, you will have a $100 profit.
($1.2188 - $1.2178) X 100,000 = $.001 X 100,000 = $100
Similarly, if you sell Euros (EUR/USD) at 1.2170 and buy Euros at 1.2180, you will have a $100 loss.
($1.2170 - $1.2180) X 100,000 = - $.001 X 100,000 = - $100
You can also calculate your unrealized profits and losses on open positions. Just substitute the current bid or ask rate for the action you will take when closing out the position. For example, if you bought Euros at 1.2178 and the current bid rate is 1.2173, you have an unrealized loss of $50.
($1.2173 - $1.2178) X 100,000 = - $.0005 X 100,000 = - $50
Similarly, if you sold Euros at 1.2170 and the current ask rate is 1.2165, you have an unrealized profit of $50.
($1.2170 - $1.2165) X 100,000 = $.0005 X 100,000 = $50
If the quote currency is not in US dollars, you will have to con- vert the profit or loss to US dollars at the dealer's rate. Further, if the dealer charges commissions or other fees, you must subtract those commissions and fees from your profits and add them to your losses to determine your true profits and losses.
The formula for calculating the security deposit is:
Current price of base currency X transaction size X security deposit % = security deposit requirement given in quote currency
Returning to our Euro example with an initial price of $1.2178 for each Euro and a transaction size of 100,000 Euros, a 1% security deposit would be $1,217.80.
$1.2178 X 100,000 X .01 = $1,217.80
Security deposits allow customers to control transactions with a value many times larger than the funds in their accounts. In this example, $1,217.80 would control $121,780 worth of Euros.
Value of Euros = $1.2178 X 100,000 = $121,780
This ability to control a large amount of one currency, in this case the Euro, using a very small percentage of its value is called leverage or gearing. In our example, the leverage is 100:1 because the security deposit controls Euros worth 100 times the amount of the deposit.
Since leverage allows you to control large amounts of currency for a very small amount, it magnifies the percentage amount of your profits and losses. A profit or loss of $1,217.80 on the Euro trans- action is 1% of the full price (with leverage of 1:1) but is 100% of the 1% security deposit. The dollar amount of profits and losses does not change with leverage, however. The profit or loss is $1,217.80 whether the leverage is 100:1 or 25:1 or 1:1.
The following examples illustrate long and short positions, the benefits and risks of margin trading and the workings of the margin account.
Assume that you start with a clean slate and that the current GPB/USD (cable) rate is 1.5847/52.
You expect the pound to appreciate against the US dollar, so you buy a single lot of 100,000 GBP at 1.5852 USD.
The value of the contract is 100,000 X 1.5852 USD = 158, 520 USD. The broker wants margin of 2.5% in USD, so you must ensure that you deposit at least 2.5% of 158,520 USD = 3,963 USD in your margin account
GBP/USD appreciates to 1.6000/05 and you decide to close out by selling your sterling for US dollars at the bid rate. Your gain is:
- 100,000 X (1.6000 â€“ 1.5852) USD = 1,480 USD
Your rate of return is 1,480/3,963 = 37.35%, on an exchange rate movement of less than 1%. This illustrates the positive effect of buying on margin.
Had GBP/USD fallen to 1.5700/75, your loss would have been-
100,000 X (1.5852 â€“ 1.5700) USD = 1,520 USD, a return of â€“38.35% illustrating the disadvantage of margin trading.
You expect sterling to fall from GBP/USD = 1.5847/52 so you decide to sell one lot of GBP/USD.
The value of the contract is 100,000 X 1.5847 USD = 158,470 USD.
Your broker requires 2.5% of 158,470 USD as margin = 3,961.75 USD in cash
GBP/USD falls to 1.5555/60 and you are sitting on a paper gain of: -
100,000 X (1.5847 â€“ 1.5560 USD) = 2,870 USD
Your 2,870 USD paper gain is credited to your margin account (variation in margin) where you now have 6,831.75 USD. This enables you to maintain open positions worth 273,270 USD
GBP/USD starts to rise. When it reaches 1.6000/05, you are sitting on a paper loss of:
100,000 X (1.6005 â€“ 1.5847) USD = 1,580 USD.
Your margin account is debited by 1,580 USD (variation in margin), taking it down to 2,381.75 USD which is sufficient to support 2,381.75 USD/0.025 = 95,270 USD worth of open positions. Your current exposure, however, is:
100,000 X 1.6005 USD = 160,050 USD
Your shortage in equity is therefore 160,050 USD - 95,270 USD= 64,780 USD
The broker makes a margin call for 2.5% of 64,780 USD = 1,619.50 USD.
You eventually close out your position at GBP/USD = 1.5720/25. Your gain is:
100,000 X (1.5847 â€“ 1.5725) USD = 1,220 USD.
You have no more open positions, so you can withdraw the full 5,181.75 USD from your trading account in cash. Alternatively, you have enough margin to support 207,270 USD worth of new positions.