What is Leverage in Forex?
What is leverage in Forex trading? Leverage is basically the method by which you could control a significant amount of money in Forex trading by borrowing a large portion of the capital from the broker. Leverage is mandatory if you are looking to trade using very little of your own money.
A standard lot ($100,000) in Forex trading can be controlled by using just $1000 of your own money. In this case, the leverage is 100:1 (which is the ratio of 100,000 to 1000). Remember! Leverage will be numerically expressed in terms of ratios.
What is margin? How is it related to leverage?
Now that you learned what is leverage in Forex, let’s look at margin. To understand what is margin- let’s go back to the earlier example: a $100,000 position in Forex trading can be controlled by using just $100 of your own money. This statement obviously refers to a leverage of 100:1.But significantly margin refers to the $1000 deposit you had to invest in order to avail this leverage. In other words, margin is collateral that you have to give your Forex broker to conduct your Forex trade using leverage. Margin helps secure your trade with your broker.
As we have learned that leverage is expressed in ratios. What about margin? How is it expressed?
Margin calculated as a percentage of the full amount of the position. It could be 1%, 2%, 3%, 5% or even 0.25% and 0.5%. Different brokers have different margin norms. Once you know your broker’s margin requirement you can figure out the maximum plausible leverage that can be availed in your trading account.
How leverage and margin are related?
Suppose, your broker has set a margin of 5%. Theoretically, it means for a $100 position you need $5. So for standard lot of $100,000 you would require (100,000 x 5) divided by 100 =$5000. This means for a $100,000 position the broker would expect you to put a margin of $5000 which translates to a leverage of 20:1 (100,000 divided by 5000). Similarly you can calculate the maximum possible leverage for different margin requirements as for example for 3%, 2% and so on.
You can clearly see from the above calculations, although leverage and margin are interrelated, leverage does not equal margin. Here’s how different margin requirements could translate to maximum possible leverage.
How leverage magnifies the profit and loss.
Suppose, we are trading with $100,000(1 standard lot) position with 1:1 leverage (which means you invested the entire cost of the position yourself and had no borrowings) has now risen in value to $102,000. This means you have made a $2000 profit and your rate of return would be a mere 2% ($2000 profit divided by $100,000 money you invested as deposit)
But, what would happen if you had a leverage of 100:1 and the $100,000 had risen to $102,000? In that case you would have invested only $1000 of your own money and the remaining $99,000 would have come as a loan from your broker. But importantly your rate of return has increased manifold, and in this instance would be 200% (divide $2000 profit by $ 1000 initial deposit and multiply that figure by 100).
From the above examples we can see that: a 1:1 leverage got you a mere 2% rate of return while a 100:1 leverage got you a 200% return.
However, some traders think that leverage is a double edged sword. What does this mean? In the examples we talked of earlier the investment had made a profit of $2000(i.e. $100,000 had risen to $ 102,000).What if it is the other way around?
With a 1:1 leverage, what if the value of the position had declined from $100,000 to $98,000? This means you lost $2000 which means a negative rate of return (-2%). If the same deal was made on a leverage of 100:1 it means even more negative rate of return (-200%). Just like an increased leverage contributes to greater profits when the trade goes your way, similarly if the trade were to go against you increased leverage will certainly result in greater losses. This is what is meant by leverage being a double edged sword.
What is Margin Call?
When broker calls (phone call, email alert) the trader to deposit more money into the account. If the trader cannot deposit, some part or all of his trades will be liquidated by the broker at the current market price.
Why Broker goes for a Margin Call?
Usually, a broker will liquidate a trade position that is losing more than 50% of the margin (this is called Minimum Margin) it uses. The reason why it happens is to preclude the possibility of your losing more money than you had originally invested.
Let’s look at this theoretical example.
Suppose you are David. Trading with a Mini account with 1% margin and have deposited $10,000. You send a buy order with 1 mini lot of EUR/USD. Your account will look as follows:
|Account No.||Balance||Equity||Used Margin||Usable Margin|
You decided to keep going with this position. Assume you decide to buy a further 60 lots of EUR/USD making it a total of 61 lots. Your account info will now look as follows:
|Account No.||Balance||Equity||Used Margin||Usable Margin|
Now, assume that the EUR/USD will start to fall, in which case your Equity will fall too. Your Used Margin will remain at $6100. But once your equity equals to the used margin or drops below $6100, you will have a Margin Call. This means that some or all of your 61 lot position will immediately be closed at the current market price, unless you take steps to increase your equity to bring it sufficiently above the used margin. This is how a margin call will be triggered.
From the above discussion, we may come to a conclusion that using high leverage is not a good idea. Having a leverage of 1:300 to 1:500 is a better choice. We would like to recommend you to use a leverage of 1:400 which you will get while trading with HYCM Broker.
To have a better idea about What is leverage in Forex and how to use leverage smartly, read this article: How to use leverage in Forex Trading
|Chapter 2||Forex Trading Basics|
|Lesson 1||Forex trading Currency pairs|
|Lesson 2||What is pip|
|Lesson 3||what is spread in forex trading|
|Lesson 4.||What is leverage in Forex|
|Lesson 5||Forex Trading Order Types|