How to Calculate Leverage, Margin, and Pip Values in Forex
Although most trading platforms calculate profits and losses, used margin and useable margin, and account totals, it helps to understand how these things are calculated so that you can plan transactions and can determine what your potential profit or loss could be.
Leverage and Margin
Most forex brokers allow a very high leverage ratio, or, to put it differently, have very low margin requirements. This is why profits and losses can be so great in forex trading even though the actual prices of the currencies themselves do not change all that much—certainly not like stocks. Stocks can double or triple in price, or fall to zero; currency never does. Because currency prices do not vary substantially, much lower margin requirements is less risky than it would be for stocks.
Before 2010, most brokers allowed substantial leverage ratios, sometimes up to 400:1, where a $100 deposit would allow a trader to trade up to $40,000 worth of currency. Such leverage ratios are still sometimes advertised by offshore brokers. However, in 2010, US regulations limited the ratio to 100:1. Since then, the allowed ratio for US customers has been reduced even further, to 50:1, even if the broker is located in another country, so a trader with a $100 deposit can only trade up to $5000 worth of currencies. In other words, the minimum margin requirement is set at 2%. The purpose of restricting the leverage ratio is to limit the risk.
The margin in a forex account is often referred to as a performance bond, because it is not borrowed money but only the amount of equity needed to ensure that you can cover your losses. In most forex transactions, nothing is actually being bought or sold, only the agreements to buy or sell are exchanged, so borrowing is unnecessary. Thus, no interest is charged for using leverage. So if you buy $100,000 worth of currency, you are not depositing $2,000 and borrowing $98,000 for the purchase. The $2,000 is to cover your losses. Thus, buying or selling currency is like buying or selling futures rather than stocks.
The margin requirement can be met not only with money, but also with profitable open positions. The equity in your account is the total amount of cash and the amount of unrealized profits in your open positions minus the losses in your open positions.
Total Equity = Cash + Open Position Profits - Open Position Losses
Your total equity determines how much margin you have left, and if you have open positions, total equity will vary continuously as market prices change. Thus, it is never wise to use 100% of your margin for trades—otherwise, you may be subject to a margin call. In most cases, however, the broker will simply close out your largest money-losing positions until the required margin has been restored.
The leverage ratio is based on the notional value of the contract, using the value of the base currency, which is usually the domestic currency. For US traders, the base currency is USD. Often, only the leverage is quoted, since the denominator of the leverage ratio is always 1. The amount of leverage that the broker allows determines the amount of margin that you must maintain. Leverage is inversely proportional to margin, which can be summarized by the following 2 formulas:
Margin = 1/Leverage
Leverage = 1/Margin = 100/Margin Percentage
To calculate the amount of margin used, multiply the size of the trade by the margin percentage. Subtracting the margin used for all trades from the remaining equity in your account yields the amount of margin that you have left.
To calculate the margin for a given trade:
Margin Requirement = Current Price × Units Traded × Margin
Example—Calculating Margin Requirements for a Trade and the Remaining Account Equity
You want to buy 100,000 Euros (EUR) with a current price of 1.35 USD, and your broker requires a 2% margin.
Required Margin = 100,000 × 1.35 × 0.02 = $2,700.00 USD.
Before this purchase, you had $3,000 in your account. How many more Euros could you buy?
Remaining Equity = $3,000 - $2,700 = $300
Since your leverage is 50, you can buy an additional $15,000 ($300 × 50) worth of Euros:
15,000 / 1.35 ≈ 11,111 EUR
To verify, note that if you had used allyour margin in your initial purchase, then, since $3,000 gives you $150,000 of buying power:
Total Euros Purchased with $150,000 USD = 150,000 / 1.35 ≈ 111,111 EUR
In most cases, a pip is equal to .01% of the quote currency, thus, 10,000 pips = 1 unit of currency. In USD, 100 pips = 1 penny, and 10,000 pips = $1. A well known exception is for the Japanese yen (JPY) in which a pip is worth 1% of the yen, because the yen has little value compared to other currencies. Since there are about 120 yen to 1 USD, a pip in USD is close in value to a pip in JPY. (See Currency Quotes; Pips; Bid/Ask Quotes; Cross Currency Quotes for an introduction.)
Because the quote currency of a currency pair is the quoted price (hence, the name), the value of the pip is in the quote currency. So, for instance, for EUR/USD, the pip is equal to 0.0001 USD, but for USD/EUR, the pip is equal to 0.0001 Euro. If the conversion rate for Euros to dollars is 1.35, then a Euro pip = 0.000135 dollars.
Converting Profits and Losses in Pips to Native Currency
To calculate your profits and losses in pips to your native currency, you must convert the pip value to your native currency.
When you close a trade, the profit or loss is initially expressed in the pip value of the quote currency. To determine the total profit or loss, you must multiply the pip difference between the open price and closing price by the number of units of currency traded. This yields the total pip difference between the opening and closing transaction.
If the pip value is in your native currency, then no further calculations are needed to find your profit or loss, but if the pip value is not in your native currency, then it must be converted. There are several ways to convert your profit or loss from the quote currency to your native currency. If you have a currency quote where your native currency is the base currency, then you divide the pip value by the exchange rate; if the other currency is the base currency, then you multiply the pip value by the exchange rate.
Example—Converting CAD Pip Values to USD
You buy 100,000 Canadian dollars with USD, with the conversion rate at USD/CAD = 1.200. Subsequently, you sell your Canadian dollars when the conversion rate reaches 1.1000, yielding a profit of 1.1200 - 1.1000 = 200 pips in Canadian dollars. Because USD is the base currency, you can get your profit in USD by dividing the Canadian value by the exit price of 1.1.
100,000 CAD × 200 pips = 20,000,000 pips total. Since 20,000,000 pips = 2,000 Canadian dollars, your profit in USD is 2,000/1.1 = 1,818.18 USD.
However, if you have a quote for CAD/USD, which is equal to 1/1.1 = 0.9090909090909, then your profit is calculated thus: 2000 × 0.9090909090909 = 1,818.18 USD, which is the same result obtained above.
For a cross currency pair not involving USD, the pip value must be converted by the rate that was applicable at the time of the closing transaction. To find that rate, you would look at the quote for the USD/pip currency pair, then multiply the pip value by this rate, or if you only have the quote for the pip currency/USD, then you divide by the rate.
Example—Calculating Profits for a Cross Currency Pair
You buy 100,000 units of EUR/JPY = 164.09 and sell when EUR/JPY = 164.10, and USD/JPY = 121.35.
Profit in JPY pips = 164.10 – 164.09 = .01 yen = 1 pip (Remember the yen exception: 1 JPY pip = .01 yen.)
Total Profit in JPY pips = 1 × 100,000 = 100,000 pips.
Total Profit in Yen = 100,000 pips/100 = 1,000 Yen
Because you only have the quote for USD/JPY = 121.35, to get profit in USD, you divide by the quote currency's conversion rate:
Total Profit in USD = 1,000/121.35 = 8.24 USD.
If you only have this quote, JPY/USD = 0.00824, which is equivalent to the above value, you use the following formula to convert pips in yen to domestic currency:
Total Profit in USD = 1,000 × 0.00824 = 8.24 USD.