Leverage and Margin Explained
Let’s discuss leverage and margin and the difference between the two.
What is leverage?
We know we’ve tackled this before, but this topic is so important, we felt the need to discuss it again.
The textbook definition of “leverage” is having the ability to control a large amount of money using none or very little of your own money and borrowing the rest.
For example, to control a $100,000 position, your broker will set aside $1,000 from your account. Your leverage, which is expressed in ratios, is now 100:1.
You’re now controlling $100,000 with $1,000.
Let’s say the $100,000 investment rises in value to $101,000 or $1,000.
If you had to come up with the entire $100,000 capital yourself, your return would be a puny 1% ($1,000 gain / $100,000 initial investment).
This is also called 1:1 leverage.
Of course, I think 1:1 leverage is a misnomer because if you have to come up with the entire amount you’re trying to control, where is the leverage in that?
Fortunately, you’re not leveraged 1:1, you’re leveraged 100:1.
Now we want you to do a quick exercise. Calculate what your return would be if you lost $1,000.
If you calculated it the same way we did, which is also called the correct way, you would have ended up with a -1% return using 1:1 leverage and a WTF! -100% return using 100:1 leverage.
As you can see, these cliches weren’t lying.
What is margin?
So what about the term “margin”? Excellent question.
Let’s go back to the earlier example:
In forex, to control a $100,000 position, your broker will set aside $1,000 from your account. Your leverage, which is expressed in ratios, is now 100:1. You’re now controlling $100,000 with $1,000.
The $1,000 deposit is “margin” you had to give in order to use leverage.
Margin is the amount of money needed as a “good faith deposit” to open a position with your broker.
It is used by your broker to maintain your position. Your broker basically takes your margin deposit and pools them with everyone else’s margin deposits, and uses this one “super margin deposit” to be able to place trades within the interbank network.
Margin is usually expressed as a percentage of the full amount of the position. For example, most forex brokers say they require 2%, 1%, .5% or .25% margin.
Based on the margin required by your broker, you can calculate the maximum leverage you can wield with your trading account.
If your broker requires 2% margin, you have a leverage of 50:1.
Here are the other popular leverage “flavors” most brokers offer:
Understanding Forex Margin and Leverage
by Walker England, Trading Instructor
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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.
When trading with margin it is important to remember 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 as well.
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 .
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.
Equity Vs Trade Size
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. Typically traders have a greater chance of long-term success when using a conservative amount of leverage . Keep this information in mind when looking to trade your next position and keep effective leverage of 10 to 1 or less to maximize your trading .
Losses on Leverage
It is vital to avoid mistakes with leverage; to understand how to avoid other issues traders might face check out our Top Trading Lessons guide.
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How does margin trading in the forex market work?
A margin account, at its core, involves borrowing to increase the possible return on investment. Investors often use margin accounts when they want to invest in equities by using the leverage of borrowed money to control a larger position than they'd otherwise by able to control with their own invested capital.
These margin accounts are operated by the investor's broker and are settled daily in cash. Margin accounts are not limited to equities – they are also used by currency traders in the forex market.
To get started, investors interested in trading in the forex markets must first sign up with either a regular broker or an online forex discount broker. Once an investor finds a proper broker, a margin account must be set up. A forex margin account is very similar to an equities margin account – the investor is taking a short-term loan from the broker. The loan is equal to the amount of leverage taken on by the investor.
An investor must first deposit money into the margin account before a trade can be placed. The amount that needs to be deposited depends on the margin percentage that is agreed upon between the investor and the broker. For instance, accounts that will be trading in 100,000 currency units or more, the margin percentage is usually either 1% or 2%.
So, for an investor who wants to trade $100,000, a 1% margin would mean that $1,000 needs to be deposited into the account. The remaining 99% is provided by the broker. No interest is paid directly on this borrowed amount, but if the investor does not close their position before the delivery date, it will have to be rolled over. In that case, interest may be charged depending on the investor's position (long or short) and the short-term interest rates of the underlying currencies.
In a margin account, the broker uses the $1,000 as a security deposit of sorts. If the investor's position worsens and his or her losses approach $1,000, the broker may initiate a margin call. When this occurs, the broker will usually instruct the investor to either deposit more money into the account or to close out the position to limit the risk to both parties.
Open positions are required to be fully margined at all times. FOREX.com does not engage in margin calls; you are responsible for monitoring your account and maintaining 100% of required margin at all times to support your open positions. To help limit your trading losses and ensure that your losses never exceed your account balance, our systems monitor your margin in near real-time and will automatically close out your open positions if your account equity falls below the 100% margin requirement. While our 100% margin requirement and near real-time margin system is designed to limit your trading losses and help ensure that total losses never exceed your total account balance, you do risk incurring losses greater than your account balance, especially during periods of extreme market volatility. While it is not FOREX.com’s policy to hold clients responsible for modest negative balances, we do reserve the right to hold clients responsible for large debit balances and when special circumstances apply. For this reason, we strongly encourage you to manage your use of leverage carefully. Increasing leverage increases risk.
Margin requirements are subject to change without notice, at the sole discretion of FOREX.com.
Please note that very large individual positions are subject to additional margin. This will typically apply to positions of $50m or more on currency pairs.
Should you have a position that is subject to an additional margin requirement we will contact you to make arrangements to cover it. This increased margin requirement will continue to apply at FOREX.com’s discretion, until the position size decreases and remains materially below the threshold for a sustained period. Partially closing the position will not automatically reduce your margin requirement.
If you have any questions about margin on large positions please contact us.