Leverage & Margin Trading Explanation & Example

Margin required : It's the amount of money your broker requires from you as a trader to open a trade transaction. It's denoted in percentages.

Equity : It is the total amount of capital you've in your account.

Used margin : amount of money in your trading account which has already been used up when buying a commodity contract, this contract is the one that's displayed in open trade transactions. As a trader you can't use this amount of money after opening a trade order because you have already used it and it is not available to you.

In other terms, because your broker has opened up a trade transaction for you using the trading capital you've borrowed, you must sustain this usable trading margin for your trading account as a security so as to allow you to continue using this leverage he has given you.

Free margin : sum in your trading account which you can use to open new trade positions. This is the sum of money in your trading account which has not yet been leveraged because you've not yet opened a transaction with this money - this money also is very important for you as a investor because it enables you to continue holding your open positions as will be explained below.

However, if you over use leverage, this free trading margin will go below a certain percentage at which your broker will have to close out all of your transactions automatically, leaving you with a big loss. Commodity broker at this point will automatically close-out all your open trade transactions because if your open transactions are left open then your broker would lose money that you'd have borrowed from them.

This is why you should always make sure you've a lot of free margin. To do this never trade more than 5 percentage of your commodities trading account, in fact two percentage is recommended.

Difference Between Leverage Set by Broker & Used Commodities Trading Leverage

If the set leverage is 100: 1, what it means is thatthat-as-a-trader you can borrow upto $100 for every one dollar you have in your trading account, but you don't have to borrow all the $100 for every one dollar you have, you can decide you want to borrow 50:1 or 20:1. In this instance though leverage option is set at 100:1 your used commodities leverage will be the 50:1 or 20:1 that you have borrowed to make a trade transaction.

Example:

You have $1000 (Equity)

Set 100:1

Commodity Trading Leverage Used = Amount used /Equity

If you buy commodity lots equal to $100,000 you'll have used

= 100,000/1000

= 100:1

If you buy commodities trading lots equal to 50,000 dollars that as a trader you will have used

= 50,000/1000

= 50:1

If you buy commodities trading lots equal to 20,000 dollars that as a trader you will have used

= 20,000/1000

= 20:1

In these 3 cases you can see that allthough the set is 100:1

The used is 100:1, 50:1, 20:1 depending on the size of commodity lots traded.

So Why not Just Choose 10:1 option as the Maximum Leverage? Because to keep within proper risk management rules it's even recommended that traders use less than this?

This question might seem straight forward but it is not, because when you trade you use borrowed money known A.K.A. Commodity Trading Leverage. When you borrow capital from anyone or from a bank you must sustain a security or collateral to acquire a loan, even if the collateral is based on monthly deductions from your own salary, the same thing with Commodities.

In commodity the security is known as margin. This is the trading capital which you deposit with your broker.

This is calculated in real time as you trade. To keep your borrowed money you must sustain what is known-asreferred-to-as the required capital (your deposit).

Now if Your Trading Leverage is 100:1

When trading if you have $1,000 & use trading leverage ratio 100:1 and buy 1 standard contract for $100,000 your margin on this transaction is $1000 dollars in your account, this is the money that you'll lose if your open trade transaction moves against you, the other amount $99,000 that's borrowed, they will close out the open commodity positions automatically once your $1,000 has been taken by the commodities market.

But this is if your broker has set 0% Commodities Trading Margin Requirement before stopping out your trades automatically.

For 20 percentage prerequisite before closing out your commodities transactions automatically, then your trades will be stopped out once your trading balance gets to $200

For 50 percent prerequisite of this level before closing out your commodities transactions automatically, then your trades will be stopped out once your trading balance gets to $500

If they set 100 Percent requirement of this level before closing out your open trade transactions automatically, then your trade position will be stopped out once your balance gets to $1,000: Meaning the trade will close-out as soon as you open it because even if you as a trader you pay 1 pip spread your account balance will get to $990 & the needed percentage is 100 percent i.e. 1,000 dollars, therefore your trading orders will immediately get stopped out.

Most brokers don't set 100 Percent requirement, but there are those who set 100% are not appropriate for you at all, choose those set 50 percent or 20% margin requisite, in fact, those commodities brokers which set their margin requisite at 20% are some of the best since due to the likely hood they stop out your trade transaction is reduced as displayed in example above.

To know about this level which is calculated by your trading software automatically - The MetaTrader 4 Trading Platform will illustrate this as "Commodities Trading Margin Requirement", This will be displayed as a percent the higher the percentage the less likely your transactions are to get stopped out.

For Example if

Using 100:1

If leverage is 100:1 and you transact commodity lots equal to $10,000

$10,000 dollars divide by 100:1, used capital is $100

Calculation:

= Capital Used * Percentage(100)

= $1,000/$100 * Percentage(100)

Commodities Margin Requirement = 1,000 %

InvestorTrader has 980% above the requirement amount

Using 10:1

If leverage is 10:1 & you trade commodity lots equal to $10,000

$10,000 dollars divide by 10:1, used capital is $1000

Calculation:

= Capital Used * Percentage(100)

= $1,000/$1000 * Percentage(100)

Commodities Trading Margin Requirement = 100 %

Investor has 80 % above the required amount

Because when one has a higher leverage means that they have more % above what is required(A.K.A. More "Free Commodities Trading Margin") their open commodity transactions are less likely to get closed. This is reason why traders will select the option 100:1 for their trading account but according to their risk management rules, they will not trade above 5:1 leverage ratio.

These Areas are Shown on The Software Image Below as an Examples:

MetaTrader 4 Trading Platform