What is Leverage AND Margin in Forex trading?
So, you know what FOREX is and how it works. In this lesson we learn the importance of leverage and margin when you invest and trade in the currency markets. Margin and leverage are among the most important concepts to understand when trading FOREX and leverage is the most influencing factor that many day traders like to join FOREX trading online.
What is leverage? Leverage is the ratio between the amount of capital you possess and the amount of capital you can utilize for trading purposes. In essence, leverage empowers you to control substantial positions in the market using a smaller portion of your own funds. In the context of forex trading, leverage can be likened to an instrument that allows traders to amplify their exposure by borrowing funds from their broker. This borrowed capital enables them to open significantly larger positions in the forex market, even if they initially deposit only a relatively small amount. Therefore, leverage represents the relationship between your deposited funds and the supplementary amount extended by the broker.
Many brokers offer leverage from 1:100 to 1:400. Usually in FOREX Market 1:100 leverage level is the most optimal leverage for trading. For example, if $1000 is invested and the leverage is equal to 1:100, the total amount available for trading will equal to $100,000.
But, always keep in mind that high leverage could be very risky especially to those traders that are newcomers to online trading. They are attracted with high leverage because of expecting a large profit with minimum investment while neglecting the fact that taking LEVERAGE with out setting proper Stop Losses can cause unlimited risk and that will result in huge loss.
Brokers usually provide key risk management tools such as stop-loss orders, which can help traders to manage risk more effectively.
Here are the basic points to manage the leverage risks properly:
- Using trailing stops
- Stop loss order
- Take profit order
- Guaranteed Stop-loss
- Keeping positions small
- Limiting the amount of capital for each position.
What is margin in forex?
Margin is the amount of money that a trader needs to put forward in order to open a trade. When trading forex on margin, you only need to pay a percentage of the full value of the position to open a trade.
For example, if you want to buy $100,000 worth of EUR/USD, you don’t need to put up the full amount, you only need to put up a portion, like $1000. The actual amount depends on your FOREX broker or CFD provider. Margin is one of the most important concepts to understand when it comes to leveraged FOREX trading. Margin is not a transaction cost.
So, Margin is simply a percentage of your equity that your forex broker keeps aside from your account balance to keep your trade open and to ensure that you can cover the potential loss of the trade.
What is Margin Requirement?
The minimum amount of money that a client must have on deposit, either in cash or approved securities, in a margin account at a brokerage office. Margin requirements for stock trading are governed by the Federal Reserve through Regulation T.
Depending on the currency pair and forex broker, the amount of margin required to open a position VARIES.
You may see margin requirements such as 0.25%, 0.5%, 1%, 2%, 5%, 10% or higher.
This percentage (%) is known as the Margin Requirement.
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 1.1000 USD, and your broker requires a 2% margin.
Required Margin = 100,000 × 1.1000 × 0.02 = $2,200.00 USD.
Before this purchase, you had $5,000 in your account. How many more could you buy?
Remaining Equity = $5000 – $2,200 = $2800
With a Margin Requirement of 2%, you may open different positions in different sizes.
Trade Size———————————– amount
100000 ————————————— 2000
1000 ————————————— 20
Next Lesson: What is CFD trading?