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AB09 - Leverage and Margin Explained

"Leverage and margin are important when it comes to the financial markets. It is not just limited to the forex markets. You can find leverage and margin even in stocks and in futures too. Therefore, having a good understanding of how leverage and margin works is important for you as a trader to manage your money. Both these concepts are very simple. Many times, you will be asked to choose your leverage right when you open your forex trading account. Only a few forex brokers allow you to change your leverage after you created your forex trading account and deposited funds. While leverage can be tempting, it is also very risky. Thus, leverage is one of the important aspects when it comes the overall risk management in your forex trading. In this article, we cover the basics of leverage and margin and what they mean. By the end of the article, you would be more familiar with both these terms."

When you trade forex, the two words that you will come across most often are leverage and margin. While they might sound different, they basically refer to the same fact. Whether you are trading on leverage, or trading on margin, it is one and the same.

However, there are some subtle differences between the two. Let’s look at what leverage and margin means individually.

What is leverage?

As the name suggests, leverage is making use of a lever in order to control large positions in the instruments that you are trading. Within the context of forex trading, leverage is nothing but putting up a small amount of money and using the broker’s money to lever up your positions.

Leverage is often synonymous with borrowed money. A simple example of how leverage is used can be seen when someone is buying a house. When you purchase a house and take up a mortgage, you are basically leveraging.

Quite often, you would be required to put up an initial amount. This could be for example 25% of the total value of the house. The bank, then funds the remaining 75%. This borrowing or mortgage is nothing much using leverage.

In finance, leverage is used just about everywhere. So, you are not alone when you think you are trading on leverage in forex. From large publicly listed companies to investors, leverage is commonly used to trade or control higher units of the security.

In forex, you will be asked to choose your leverage quite early on. Leverage can start from 1:1 meaning no leverage and can go as high as 1:200. Expressed as a ratio obviously, it tells you how many times you can increase your capital.

Therefore, a 1:200 leverage means that for every 1 dollar that you put up, you can borrow, 200 dollars. This allows you to trade larger lot sizes in forex. If you do not want to trade on leverage, you will of course need to have a good capital to begin with.

So, for example if you deposited $1000 and opted for a 1:100 leverage, this allows you to trade 100,000 contracts.

What is trading on margin?

Trading on margin is basically another way of calling leverage. When you trade on margin, you are trading on borrowed funds from your broker. Of course, you are obligated to pay back the borrowed funds to your broker.

The amount of money you deposit is basically known as the margin amount. So, if you deposited $10,000 and opted for a 1:100 leverage, this means that you are trading on a $10,000 margin account. The leverage on the other hand, allows you to trade up to 1,000,000 units of currency.

When your capital falls below a certain threshold that you should maintain, it results in a margin call. A margin call occurs when you are required to top up your trading account. If your account falls below a certain threshold and if you ignore the margin call, it could basically lead to the forex broker liquidating your open positions, regardless of whether they are trading at a profit or a loss.

Is Margin and Leverage good to use?

You might have mixed feelings about margin and leverage. They are both good and bad. Margin and leverage is good because it allows you trade higher contract sizes. This in turn can maximize your profit potential.

But at the same time, when a trade goes against your favor, there is a high risk that you could lose more than what you initially deposited. Many forex brokers clearly outline their leverage and margin trading rules.

You will be informed about the margin requirements and most of the times, your leverage is limited to 1:200, in order to prevent forex traders from taking on undue risk.

Without the use of leverage or margin, also known as cash trading requires the trader to put up huge capital. If you think about it, trading without margin in the forex markets means that you will need to have at least $100,000 in order to trade. Even with this amount of money, the maximum contract size you can trade is at most one mini lot.

You can see from the above that not trading on margin or leverage can greatly limit your profit potential. Choosing the right leverage is important as tells you upfront how much of money you are risking.

While leverage can be tempting due to the fact that it can allow you trade larger units, they are risky as well. If you do not have a good trading strategy but highly leveraged, it can be a recipe for disaster.

Read 1009 times Last modified on Saturday, 08 June 2019 08:25