Risk management is important whatever the traded instrument but especially for anyone using margined products such as the Forex. Trading on margin opens up the possibility of greater potential profits but at the risk of larger losses. With some leveraged instruments, potential losses are not restricted to the cash committed to the margin account, instead additional capital calls can be made if large losses are incurred.
In Forex this cannot happen and clients cannot lose any more money than they have deposited as a margin. Forex broker-dealers automatically liquidate their customer positions almost as soon as they trigger a margin call. For this reason, Forex costumers are rarely in danger of generating a negative balance in their account.
Most Forex boker-dealers offer very high leverage, so a 1k deposit would allow the trader to control a bigger amount of capital. However, and this is the dangerous part of this method, even a few pips move against the trader would trigger a severe loss or even a margin call.
Regardless of how much leverage the trader assumes, this controlled parsing of his or her speculative capital would prevent the trader from blowing up the trading capital in a string of bad trades. At the same time, it would allow the trader to take advantage of a potentially profitable strategy without the worry or care of setting fixed stop loss orders. This leads us to the next point.
Since the idea of risk management and not over leveraging accounts remains a lingering issue for many aspiring traders, we are going to run some numbers and use an exercise to calculate the free margin accordingly to the leverage, hoping this will make these concepts a little clearer.
Let’s say you have an account balance of 10,000 US Dollar and a maximum allowed 200:1 leverage. At the start, with no open positions, the usable margin is at 100%.
You decide to open a trade using 2% of the available margin. Now, no matter how many pips you think you can pull from a trade, suppose you’ve decided to use a 2% entry- this is how much margin you’re going to use.
And no matter how attractive a trade looks or how promising the Return is, you’re going to stay disciplined by only using this set amount of equity.
Here’s how you determine how much a 2% entry is:
- Core Equity (Usable Margin): 5,000 USD
- Used Margin: 2%
- 5,000 X 0,02 = 100 USD
With a 200:1 leverage an entry of 100 US Dollars will net you 2 US Dollars per pip. The reason is that 100 US Dollars leveraged 200 times is 20,000 USD which equals to 2 mini lots, which in turn pays approximate 2 US Dollars per pip.
So after the trade is executed, your account shows:
- Balance: 5,000 USD
- Usable Margin: 4,894 USD (entry size plus the spread of 3 pips at 2 USD per pip = 6 USD)
- Used Margin Percentage: 2.1% (after factoring in the spread)
- Entry Price: 1.3790
Market moves against you by 20 pips and is now at 1.3770. After the market moves against you, notice how the used margin percentage changes:
- Usable Margin: 4,854 USD
- Used Margin Percentage: 3.0% (4,854 – 5,000 = 146 USD → 146 / 4854 = 3.0%)
The exchange rate moves against you another 30 pips and is now at 1.3740. Again, this alters the used margin and therefore free (usable) margin:
- Usable Margin: 4,794 (30 pips of Drawdown at 2 USD per pip = 60 USD → 60 – 4,854 = 4,794 USD)
- Used Margin Percentage: 4.3% (4.794 – 5.000 = 206 → 206 / 4.794 = 4.3%)
- Usable Margin Percentage: 95.7% (100 – 4.3 = 95.7%)
This is basically how you do the math to determine your margin usage, your available margin, and what kind of risk exposure you have in the market. The other critical component is knowing how far the market can move against you before you damage your account.
Continuing with this exercise…
- Usable Margin: 4,794 USD
- Entries: 2
- Price Per Pip: 4 USD (2 entries at 100 USD each, leveraged 200 times = 4 USD per pip)
- Used Margin Percentage: 4.3%
- Usable Margin Percentage: 95.7%
With an usable margin of 4,794 USD and each pip movement accounting 4 USD, the market would need to move 1,198 pips against you before you get a margin call.
4,794 USD / 4 USD per pip = 1,198 pips (4 USD X 1,198 = 4,792 USD)
That means the exchange rate would have to go to 1.2542 before a margin call happens: (1.3740 – 1,198 pips = 1.2542)
As long as you are not over-leveraged, you can withstand the Drawdowns.
Again, as a risk and money manager, it is imperative you know these simple and basic calculations.
In this example you had a 200:1 leverage. Does this mean you can risk more because just because you are leveraged? Absolutely not, it means you can risk less in terms of percentage and get the same reward.
Never let your margin fall below your broker’s required threshold. When you have open trades, always monitor what is happening to your margin. Some margin calls occur when your margin falls below 30%, some brokers call at 20%. Find out what are the requirements of your broker.
Here’s a nice video explanation from Wall Street Survivor.