Leverage and Margin

Let’s say you decided to invest in forex market. For starters, you have to open a margin account (minimum account size) with a forex broker of your choice. As soon as you deposit your money you will be able to enter the trading market. Your broker will let you know what is the requirement per position (lot) traded.   

When you talk about Leverage, think about a loan. Who gives away this kind of loan? Forex broker who takes care of the trader’s account provides the loan. Possible options of leverage are 50:1, 100:1 or 200:1 depending on a broker and the size of the position you are trading.  

Standard lot size is USD $100,000 so for a trade of this size the leverage is usually 50:1 or 100:1. 

For a trade smaller then $50,000 (mini lot size -USD $10,000) the leverage is usually 200:1. 

Sounds a bit crazy, but that’s the way the cookie crumbles! That being said, lets see yet another example: 

For your deposit of, let’s say, $1,000 you can trade 1 lot of $100,000. And with $7,000 you will trade up to $700,000. In this example the broker asks a 1% margin (minimum security) for each lot – for every $100,000 traded, the broker wants a deposit of $1,000. First, let’s look at the example of trading without margin.  

SCENE 1: You have opened an account of $1,000 with 100:1 leverage. So basically you have the purchase power of $100,000. And you see that USD/JPY exchange rate at 109.3. 

In case you decide to trade without margin, you only have $1,000 of buying power. With $1000 the maximum amount of Yen you can buy is 109,300 Yen. Not sure how we came up with this number? Here is the explanation: 

USD/JPY exchange rate at 109.3 

Base currency = USD. The base currency always has a value of 1. This means that for 1 USD you can buy 109.3 JPY. This also leads to the conclusion that for 1,000 USD you can buy 1,000 x 109.3 = 109,300 JPY.  

SCENE 2: Later on you see that USD/JPY exchange rate at 109.0. It is time to see off your Japanese Yen and get some profit! How much dollars can you get for 109,300 JPY at the current exchange rate? Let’s calculate: 

109,300 / 109.0 = USD 1002.75  

CONCLUSION: So, initially you had USD $1,000 and now you have got USD $1002.75. Your profit is

1002.75 -1,000 = $2.75 

Now let’s consider the same example but trading with margin 

What is margin in forex?

Forex margin rates are usually expressed as a percentage, with forex margin requirements typically starting at around 3.3% in the UK for major foreign exchange currency pairs. Your FX broker’s margin requirement shows you the amount of leverage that you can use when trading forex with that broker.

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. Margin is one of the most important concepts to understand when it comes to leveraged forex trading, and it is not a transaction cost.

Margin is the money you need to open a position with one of the brokers.

SCENE 1: With margin, your account of $1,000 has a power of $100,000. You buy Japanese Yen while USD/JPY exchange rate at 109.3. How much Yen did you get for $100,000?  

100,000 x 109.3 = JPY 10,930,000 

SCENE 2: Now USD/JPY exchange rate at 109.0 and you want to buy USD back. How much can you get? 

10,930,000 / 109.0 =100,275 

CONCLUSION: The profit you have made in this trade is 100,275 – 100,000 = USD $275. 

The given examples are of course much simpler then the real marketing situation, but it illustrates the main trading idea in a comprehensive way. 

Leverage can be represented as a ratio or in terms of margin percentage. In order to understand both representations, remember this:

            Leverage = 100 divided by Margin Percent 

           Margin Percent = 100 divided by Leverage

Leverage is represented by a ratio – 50:1, 100:1, or 200:1 and higher. Most brokers offer leverage up to 1:500. There are a few that provide much higher and riskier leverage ratio up to 1:1,000. Before you choose very high leverage, consider the risks involved in case of market fluctuations.

Pros and Cons of Leverage Trading

Pros

  • With a small capital, you can significantly boost your returns
  • You can get access to expensive stocks
  • You can open many positions with a small capital

Cons

  • Improved risk as losses can happen much more quickly
  • Managing many leveraged positions can be tricky

Pros and Cons of Margin Trading

Pros

  • Improves the buying power
  • Allows you to diversify into other instruments
  • Better return potential

Cons

  • You have to maintain and meet all margin requirements
  • High risk
  • Interest is charged

Margin and leverage: the difference

Leverage in Forex is borrowed capital that allows you to increase your trading volume and potential returns. It is a sum of money brokers lend to traders to have greater flexibility when trading on Forex.

Margin, on the other hand, is the sum of money required from traders to open a position. The funds held in a trader’s account are the money used as a margin. It is needed to cover potential losses that may occur during trading. The margin requirement depends on the leverage ratio, lot size, and instrument and can be found in the trader’s account.

Both leverage and margin are vital. Leverage gives you more power in your trades, and margin protects your balance from going below zero. Use this knowledge to succeed, and good luck!

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