The Foundations of Forex: How Leverage, Margin, and Pip Values are Calculated
While most modern forex platforms automate the process of calculating your profits and losses, as well as your margins and account totals, it is highly beneficial to understand how these numbers are actually calculated. Not only is this important to understand in order to better comprehend the workings of the market, it will also help you better assess your future profits or losses on a more personal level.
A good place to begin is the leverage and margins, as that is something you need to be familiar with before entering into a trading transaction. A vast majority of forex brokers offer a relatively high leverage ratio compared to other markets. In other words, they require a very low margin in order to begin trading. Because of this unique characteristic of the forex market, the potential for gain is enormous, as the trader does not need to invest as much as they would in the stock exchange for example. What is interesting about this, is that even though stock prices fluctuate much more than currency does (a stock can double or triple in price or alternatively be reduced to zero, whereas the USD is not going anywhere so fast), the potential for great profit or loss in the forex market is so much greater. This exact explanation is what makes it possible for brokers to work with such low margins, where in the stock market, these margins would present a much greater risk, with the sharp increases and decreases of stock value.
Most brokers offer traders a 100:1 leverage, meaning for every $100,000 transaction, you need to have $1,000 in your account. Some brokers even offer what is called a Mini-Account which has a 200:1 leverage.
The margin provided by the brokers is basically a means for them to ensure that the trader has enough equity that will act as a form of insurance for their losses. So, if you are trading with a leverage of 100:1 and you have a margin of $1,000, you are not borrowing the other $99,000, you do not pay interest on that money, nor can you lose more than the money you have invested, namely, your margin. As opposed to the stock market for example, where if you buy $100,000 worth of stocks, you now have an asset and those stocks are yours, as if you had $100,000 in your bank account, that is not the case in forex.
Another unique characteristic of forex is that your equity is not only the amount of actual money in your account, your unrealized profits are also calculated as part of your margin. So to simplify things, your equity is the amount of cash in your account in addition to all your unrealized profits minus the losses in your open positions.
This last point is important because your equity basically determines how much margin you have left in your account, and varies according to the movements of the market. Since your equity is dynamic and therefore your margin is dynamic, it is never effective to use all of your margin on trades, since you can lose it all and thereby be subject to a margin call. If you do use 100% of your margin on trades and lose, most brokers will automatically close your biggest losing positions until their required margin has been met again.
When understanding how margins and leverages are calculated, it is inherent you understand this one point. A leverage and margin are inversely proportional. So if for example, a broker offers a 200:1 leverage, and the transaction is for $200,000, you will need to invest $1,000.
Here are a few formulas to understand basic forex calculations.
To calculate a margin percentage, simply divide the number 100 by the leverage ratio. So, for example, if you have a leverage ratio of 100:1 and you want to know the margin percentage, divide 100 by 100, which gives you a margin percentage of 1%.
To calculate a leverage ratio, simply divide the number 1 by the margin or the number 100 by the margin percentage.
To calculate how much margin you need for a transaction, multiply the size of the trade by the margin percentage, or the current price multiplied by the amount of units traded multiplied by the margin, that gives you the margin requirement.
After we understood how a margin and leverage is calculated, let's try to figure out how pip values are calculated. In a majority of currencies, a pip equals .01% of the currency, so 10,000 pips=1 unit. To make things a little more concrete, let's examine the US dollar when it comes to pip value. 100 pips is equal to 1 cent and 10,000 pips equals $1. This is the equation in most cases, but a well known exception is the Japanese Yen. The Yen is worth relatively so little, that each pip is not worth a ten thousandth of a unit but rather each pip is 1% of a Yen.
When you are trading one currency against another, the value of the pip is in the quoted price not the base price. So for example, if the position is EUR/USD, the pip value is in USDs (.0001 USD). However, for USD/EUR, the pip value is .0001 EUR. If the conversion rate from Euro to Dollars is 1.35, then a Euro pip equals 0.000135 dollars.
Since most calculations in forex are displayed in pips, in order to understand your gains or losses, you will need to convert your pips to your currency. Let's take the USD for example. If you close a trade, to determine your total loss or gain, you must first multiply the pip difference by the number of units traded. This will give you the total pip difference between the opening and closing of the trade. If the quoted price is USD then the pips are expressed in USD, but if the USD is the base currency, you will need to convert the pip value to USD.
Converting the pip value to USD is a pretty simple equation. You just take total pip profit or loss and divide it by the conversion rate.
To summarize, these concepts and calculations are pretty basic in the forex market, and although not something you must know in order to trade, can help you to understand the market and how it operates.