Understanding Forex Margin and Leverage

What is Margin?

Using margin in Forex trading is a new concept for many traders, and one that is often misunderstood. Margin is a good faith deposit that a trader puts up for collateral to hold open a position. More often than not margin gets confused as a fee to a trader. It is actually not a transaction cost, but a portion of your account equity set aside and allocated as a margin deposit.
The advanced dealing rates window, found in the #FXCM Trading Station pictured below, will show you specifically how much margin is required to hold open one 10k position in a standard trading account. It is important to remember that this value represents one trading lot and that the amount of margin needed to hold open a position will ultimately be determined by trade size. As trade size increases your margin requirement will increase exponentially.

What is leverage?

Leverage is a byproduct of margin and allows an individual to control larger trade sizes. Traders will use this tool as a way to magnify their returns. It’s imperative to stress, that losses are also magnified when leverage is used. Therefore, it is important to understand that leverage needs to be controlled.

FXCM provides flexible leverage to its clients. You can trade with no leverage at all, or you can trade with a significant amount of leverage based off of your personal preferences. Let’s look at an example using effective leverage

Let’s assume a trader chooses to trade one mini lot of the USD/CAD. This trade would be the equivalent to controlling $10,000. Because the trade is 10 times larger than the equity in the trader’s account, the account is said to be leveraged 10 times or 10:1. Had the trader bought 20,000 units of the USD/CAD, which is equivalent to $20,000, their account would have been leveraged 20:1.

Effects of leverage

Using leverages can have extreme effects on your accounts if it is not used properly. Trading larger lot sizes through leverage can ratchet up your gains, but ultimately can lead to larger losses if a trade moves against you. Below we can see this concept in action by viewing a hypothetical trading scenario. Let’s assume both Trader A and Trader B have starting balances of $10,000. Trader A used his account to lever his account up to a 500,000 notional position using 50 to 1 leverage. Trader B traded a more conservative 5 to 1 leverage taking a notional position of 50,000. So what are the results on each traders balance after a 100 pip stop loss?

Trader A would have sustained a loss of $5,000, loosing near half their account balance on one position! Trader B on the other hand fared much better. Even though Trader B took a loss off 100 pips, the dollar value was cut to a loss of $500. Through leverage management Trader B can continue to trade and potentially take advantage of future winning moves. FXCM believes clients have a greater chance of long-term success when a conservative amount of leverage is used in their trading. Here is a recent study completed of thousands of FXCM accounts (“Traits of Successful Traders: How Much Capital Should I Trade Forex With?”). Keep this information in mind when looking to trade your next position and keepeffective leverage of 10 to 1 or less to maximize your trading.

---Written by Walker England, Trading Instructor

Eurozone Recovery Continues

 2yr swap spreads have declined dramatically this year, and that's an excellent indication that the Eurozone financial system is once again liquid and healthy. This in turn is a good sign that the Eurozone economy is likely to be improving in coming months (i.e., swap spreads are good leading indicators of financial and economic health).

We can't say that the Eurozone is out of the woods yet, since more than a few countries have yet to address their fundamental problem: excessive public sector bloat and chronic deficits. But with the health of the financial markets restored, there is hope that fundamental reform is in the offing.

The Euro Stoxx index is up over 20% since early June, another early sign that things are starting to improve on the margin. I note that with this index is trading at about 10 times expected earnings, it is fair to say that Eurozone markets are still suffering from deep pessimism. As in the U.S., the Eurozone equity market is being driven not by optimism, but by a slow decline in pessimism; conditions have not turned out to be as bad as the market had feared.

Equities Rise With Inflation Expectations

The chart below provides strong support for my belief that equities are responding more to inflation expectations than they are to real growth expectations. That is consistent with the monetarist view that the Fed has very little control over real growth—you can't print your way to prosperity

The chart compares the S&P 500 to the market's forward-looking inflation expectations, the 5-yr, 5-yr forward implied inflation rate embedded in TIPS and Treasury prices.

Equities benefit from QE3 because it is likely to boost nominal GDP growth, but not necessarily real growth. Inflation is now much more likely than deflation, and future cash flows are likely to be better than expected.

This is all good news for now, but lurking in the shadows is the issue of how the Fed is going to reverse its quantitative easing in the future, and whether they can do it in a timely fashion to avoid inflation going too high.

Meanwhile, it's good to see Treasury bond yields and equities on the rise. Higher yields are symptomatic of an improved outlook.

The Business of the Federal Government is Redistribution

This post builds on an excellent post by Mark Perry. Money quote: "... the federal government has become an entitlements machine. As a day-to-day operation, it devotes more attention and resources to the public transfer of money, goods and services to individual citizens than to any other objective, spending more than for all other ends combined."

Mark's charts show the composition of federal spending and taxes as a share of total spending and total taxes; mine show them as a % of GDP. Note the relatively low level of defense spending today, even though it includes all the costs of foreign wars. Defense spending is dwarfed by transfer payments.


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Global Recovery Perspective

Despite all the continuing problems in the Euro-zone (the #Euro Stoxx index is only up 38% from its recession lows, as compared to the 111% gain of the S&P 500), and the slowdown in China (the Shanghai Composite index is only up 25% from its October '08 lows), the global equity market has posted a 92% gain since early March '09, according to Bloomberg. We are still 20% below the 2007 highs, so it's still far from a complete recovery, but it's not unimpressive: global equity markets have recovered $23.6 trillion of their 2008-9 losses.

Jackson Hole Swing Trade

Fed Chair Ben Bernanke much awaited speech via Jackson Hole has all in 'wait mode'. If Ben doesn't deliver surely the financial s will suffer, and more so those financial s that have fingers in Europe crisis mess. Here is a swing trade to consider.




Goldman Sach traveled to $105 of weak volume, and now its waiting for direction. GS could follow the seasonal bearish September south if Ben speech has no.gif?lastmodified=201208270000ts in it. A bearish option spread seems the best play.

Time to Follow the Herd ; Jack Hough

          Investors continue to pull more money out of stock mutual funds than they are putting in. Should you join them?   

Net outflows were $3.2 billion for the week ended Aug. 15, according to data released Wednesday by the Investment Company Institute, a fund-industry trade group. Outflows have exceed $400 billion over the past five years.

One way to interpret the flow data is that, after 30 years of Treasury bonds offering better total returns than U.S. stocks, "the cult of equity is dying," to borrow a phrase from bond king Bill Gross's August investment outlook. If investors are losing their appetite for stocks, maybe it is time to take profits.

Then again, the Standard & Poor's 500-stock index's 13% total return so far this year hardly suggests stocks have lost their shine. Maybe the outflows mean the famously dumb herd is getting it wrong again, and that more handsome returns are in store for stocks.

Which reading is right? Neither, for two reasons -- one of which points to some important actions investors should take.

The first reason is that it is far from clear that mutual-fund flows predict stock-market returns.

During periods where the two measures seem to track each other, it seems more likely that investors chase stock-market returns rather than the other way around, says Brian Boyer, a visiting finance professor at the University of California, Los Angeles, who examined more than a half-century of fund flows and returns for a paper published in the Journal of Empirical Finance in 2009.

In other words, investors who are trying to read the market's next move in fund flows might as well be asking a Magic 8 Ball. ...

 Investors Aren't Fleeing

The second reason is that a close look at the flows suggests investors aren't exactly fleeing stocks now.

For one thing, net outflows are tiny relative to the amount of money investors have in stock funds -- less than one-half of 1% this year, says Matthew Lemieux, an analyst at data firm Lipper.

Also, while investors have pulled money out of stock mutual funds this year, they have added an even greater amount to stock exchange-traded funds, according to Lipper.

That isn't quite the death of equities, but it is a serious maiming of equity fees. ETFs tend to passively track indexes and carry lower costs than actively managed mutual funds, says Todd Rosenbluth, a mutual-fund analyst at S&P Capital IQ.

As for the larger outflows of the past five years, they partly are explained by the baby boomers beginning to turn 65 last year, says Shelly Antoniewicz, an economist at the Investment Company Institute. Investors typically sell some stocks and buy more bonds in retirement because the latter are generally less prone to sharp price swings.

The outflows also are a reasonable response to the stock plunge that hit bottom in March 2009, Ms. Antoniewicz says.

ICI research shows that fewer investors are going all-in on stocks these days, and more are seeking diversification. Money is flowing into bond funds and into hybrid funds that invest in both stocks and bonds.

Flows also are positive this year for funds that hold non-U.S. stocks. That seems more a sensible rebalancing of positions than return-chasing. U.S. shares have gained 20.4% over the past year, versus 1.7% for shares in the rest of the world, according to index publisher MSCI.

Come to think of it, the herd hasn't looked so dumb lately.

Take the move to ETFs. On average over the past decade, 57% of active fund managers failed to beat their benchmark indexes after fees, according to S&P. Last year, 84% underperformed.

With mutual funds, you don't get what you pay for. Rather, what you pay comes directly out of what you get. So pay less. This column has long recommended low-cost mutual funds and ETFs from Vanguard Group, Charles Schwab (SCHW: 13.10, -0.17, -1.28%) and others.

Investors who haven't rebalanced their portfolios lately should consider following the herd. The easiest way to get global diversification is with an all-world ETF like Vanguard Total World Stock (VT: 47.35, -0.02, -0.04%), which costs $22 a year per $10,000 invested, plus a commission to buy and sell. It has a 42% stake in the U.S., which more or less reflects the weighting of U.S. shares in the world.
Rebalancing Act

A cheaper route -- and one that allows for more U.S. exposure for those who want it -- is to use two separate funds and rebalance them from time to time. For example, Vanguard Total Stock Market (VTI: 72.24, -0.01, -0.01%) and Schwab International Equity (SCHF: 25.25, -0.01, -0.04%), both ETFs, cost just $6 and $13 a year per $10,000 invested, respectively.

For a bond ETF, SPDR Barclays Capital Aggregate Bond (LAG: 58.96, 0.06, 0.10%) offers broad exposure to Treasurys, mortgage securities, corporate bonds and more. It costs less than $18 a year per $10,000.

To figure out how much to put in stocks versus bonds, either pay a financial planner to tell you or search online for "Vanguard portfolio allocation models" to see how nine different mixes of stocks and bonds have historically performed.

The past 30 years aside, stock-heavy portfolios have generally provided higher long-term returns, but also deeper single-year declines.

The three "balanced" portfolios Vanguard recommends call for mixes of 60/40, 50/50 and 40/60. If you aren't sure, one of those is a good place to start.