Leverage and Margin Trading Explained: Margin Calls, Financing and Position Size

Leverage is what makes it possible to trade EUR/USD worth $110,000 with a few thousand dollars. It is also the reason a small price move can take a large part of an account. This article explains how margin is calculated, what margin calls and stop-outs are, what overnight financing costs, what limits regulators put on retail clients, and why the amount of leverage you use should come from your stop, not from the broker's maximum.

What leverage and margin are

Leverage means controlling a position worth more than the money you put up. The deposit you set aside to hold the position is called margin. It is not a fee. It is collateral that stays in your account and is released when the trade closes, while your profit or loss is added or subtracted.

A worked example: one lot of EUR/USD

Assume EUR/USD at 1.1000 and a USD account. One standard lot is 100,000 euros, a position value of $110,000. At 30 : 1, the margin is 110,000 / 30 = $3,666.67. At 20 : 1 it would be $5,500.

A 100-pip move on one lot is worth $1,000 whichever leverage ratio applies. Against the $3,666.67 of margin, that is a 27.3% swing. Measured against the whole position, the same move is only 0.91% (0.0100 / 1.1000). Leverage did not change the profit or loss on the trade. It made it possible to hold a position that big relative to the deposit.

That is the key idea. Profit and loss are set by position size. The leverage ratio only decides how little margin you need to open it, and so how much room a small account has to take on more size than it can survive.

Equity, free margin and margin level

Platforms report a few related numbers. Names vary slightly, but the common definitions are:

• Equity: account balance plus or minus the open profit or loss.
• Used margin: the total margin locked up by open positions.
• Free margin: equity minus used margin, the room left to absorb losses or open new trades.
• Margin level: equity divided by used margin, shown as a percentage.

Take a $5,000 account holding the one lot above. Used margin is $3,666.67, free margin is 5,000 - 3,666.67 = $1,333.33 and margin level is 5,000 / 3,666.67 = 136.4%. If price moves 50 pips against you, equity falls to $4,500, free margin to $833.33 and margin level to 122.7%.

Margin call and stop-out

A margin call is a warning from the broker that your equity has fallen close to the margin your positions need. You may be asked to add funds or reduce positions. A stop-out is the automatic closing of positions, usually starting with the largest loser, when margin level falls to a lower threshold. Both levels are set by the broker and differ between firms and account types, and some brokers use the terms differently.

As an illustration only, assume a margin call at a margin level of 100% and a stop-out at 50%. In the example account, a margin level of 100% means equity of $3,666.67, a loss of $1,333.33, or 133 pips on one lot. A 50% level means equity of $1,833.33, a loss of $3,166.67, or about 317 pips. By then the account has lost 63% of its value. Gaps and fast markets can push the actual closing price beyond these levels, which is why regulated retail firms in the UK and EU must also offer negative balance protection, covered below.

Size the position from your stop, not from your leverage

Maximum leverage tells you the largest position the broker will allow. It says nothing about the position you should hold. Position size should come from how much you are willing to lose and how far away your stop is, as in the previous article on how much to risk per trade.

On the $5,000 account, risk 2%, or $100, on a trade with a 50-pip stop. Lots = 100 / (50 x 10) = 0.2. The position value is 0.2 x $110,000 = $22,000, and the margin at 30 : 1 is $733.33.

With the same 50-pip stop, the full lot would lose $500, or 10% of the account, instead of 2%. The broker's 30 : 1 allows both. Only the sizing rule separates them. Effective leverage is a useful number to check: many traders keep it well below the broker's cap.

A share CFD example

Say a trader buys 100 shares of a stock priced at $200 as a contract for difference (CFD), with margin of 20%, which is 5 : 1. The position value is $20,000 and the margin is $4,000. A 5% move in the share is $1,000, which is 25% of the margin. A 20% fall in the share price would be a loss of $4,000, wiping out the whole margin on that position. Leverage is symmetric: it multiplies gains and losses on the money you posted by the same factor.

Overnight financing

Leveraged positions are financed. A CFD provider is effectively lending you the part of the position you did not pay for, and holding it past the daily cut-off time usually adds a financing charge or credit. It is calculated on the full position value, not on the margin.

The 7% is an assumed figure. In practice the annual rate is a benchmark interest rate plus a markup on long positions, and a benchmark minus the markup on short ones, which can still be a charge when rates are low. Some providers use 360 days for some currencies, and many charge three days at once over a weekend rollover. Against the $4,000 of margin, 30 days of that example costs about 2.9%. Forex positions have a similar mechanism, called swap, which depends on the interest rate gap between the two currencies. See Costs of Opening and Holding a Forex Trade for how it works.

Retail leverage limits by regulator

Regulators cap leverage for retail clients because losses on leveraged products can be rapid. The main regimes, as set out by the regulators:

These limits apply to retail clients. Clients classified as professional can be offered more under conditions, and firms outside these regimes may advertise much higher ratios with less regulatory protection. Rules are reviewed and renewed, so check the current position with your regulator before relying on a figure here.

Practical rules for using leverage

• Size from the stop and risk percentage first. Check the margin afterwards.
• Keep used margin well below equity so a normal adverse move does not trigger a margin call.
• Know your broker's margin call and stop-out levels and how it closes positions.
• Include financing in the cost of any trade you plan to hold for days.
• Treat the maximum leverage as a ceiling set by regulation, not as a target.

Leveraged products can lose money quickly and a large share of retail accounts lose money on them. Regulators require firms to display that share. Nothing in this article is advice on how much leverage to use.

Sources: ESMA's product intervention measures on CFDs (2018), the FCA's policy statement PS19/18 and its CFD press release, ASIC's CFD product intervention order and its extension announcement, and 17 CFR 5.9 from the CFTC. Examples use invented prices and assumed rates. Next in the series: Where to Place Stop-Loss and Take-Profit Orders.