What is Leverage in Forex?
When the time comes and an individual decides to become a player on the foreign exchange market and become a trader, they must realize that any legitimate trader must know the basic concepts behind the $5 trillion market that is Forex. One of the most important concepts in forex is leverage, and you are likely to come across it as soon as you proceed towards opening an account and filling it with your capital. Immediately, dozens of questions appear. What is it? What is the best choice? How are they different?
Leverage, in essence, is the act of borrowing capital from a broker in order to increase profits. As one of the key players of Forex, brokers are permitted to lend capital to traders, which allows the latter to gain access to a significantly wider range of investment funds. However, these new investment capabilities also mean that the trader will incur losses to the same extent as his winnings.
Brokers can afford these kinds of operations, since their losses are limited by the trader’s account balance. As soon as the losses reach the total amount of money in the trader’s account, the broker will automatically close all of the trader’s current positions. This will allow traders to avoid losing more money than they have on their accounts. It will also help them avoid owing money to the broker.
Amount of Leverage
When using leverage while opening a new position, the trader receives a capital loan, but the money isn’t actually transferred into his account. The trader can, however, track the current results of the open positions activity. Since each item is more expensive now, price fluctuations in one direction or another will bring significantly higher profits or losses.
When the trader opens a position, the fluctuating price moves either towards the trader’s position or against it. Each mark in the price’s movement corresponds to a certain amount of investment capital that is either added or subtracted from the trading account. Should the exchange rate be moving towards the trader’s position, he will be making money. If against it, he will be sustaining losses.
Currency trading is done in the form of contracts for a certain number of so-called standard lots. Each lot is equal to 100,000 units of currency. If the dollar is used as the quotation currency and the trader opens a position for one standard lot, then he buys or sells 100,000 units of this currency.
Since price fluctuations of currencies are measured in points — that is, each item has a share of 0.0001, — when trading with a standard lot, each item costs $10 (0.0001 x $100,000 = 10). If the transaction brings 10 points of profit, the trader earns $100. If the price goes 10 points to the opposite side of the position, then the trader loses $100.
Not everyone has a capital that allows them to trade currencies in the amount of $100,000, so you can use leverage in these cases. Basically, you borrow money from your broker to make a deal with $100,000 in the absence of an actual $100,000 in your trading account.
What is Margin in Forex?
Depending on the broker and account type that you have, leverages will differ. For example, 1:100 leverage means that the amount lent to the trader is 100 times higher than the balance of his trading account. If a broker offers a 1:100 leverage, then a trader can purchase a standard lot, which is equivalent to $100,000 currency, for only $1,000. These $1,000 are what’s called the margin. This means that a trader can open a position where each item costs $10, and earn $100 from just 10 points of the price’s fluctuation, while having only $1,000 in his account instead of $100,000.
Therefore, in simpler terms, margin is essentially the security deposit required to trade using leverage. It is used by the broker for maintaining your positions. In fact, some brokers take your margin deposit and combine it with that of other traders with the same deposits and use it as a super margin deposit for trading in the interbank network.
Margin is a representation of a certain percentage from the position’s total amount. You will find that most brokers have a requirement for margins to be in the 2%-0,25% range. Based on your broker’s margin requirements, you can calculate the maximum allowable leverage available to you. If your broker requires a 2% margin, you will get a 1:50 leverage. At 1:100 leverage – 1% margin, and at 1:200 leverage — 0,5% margin.
At one point or another, you will likely encounter other terms related to margin. In order to avoid further confusion, here are what some of them mean.
Margin — the simple term we just talked about. This is the amount of money your broker needs to open a position. It is expressed as a percentage.
Account Margin — your trading capital, all funds that you have access to on your account.
Used Margin — this is the capital that will be blocked in order to keep other positions open. While this capital does belong to you, you do not have access to it until the broker gives it back, until the position is closed, or until a margin call occurs.
Free Margin — capital in your trading account that is available for opening new positions.
Margin Call — a notification you get when your account balance falls below the margin level. In this case, some or all of your open positions will be closed by the broker at market prices.
To sum up everything you need to know here:
- Leverage is borrowing capital in order to increase profits;
- Trading on the foreign exchange market is carried out under contracts called “lots”;
- The standard lot is represented by 100,000 units of currency. If using the US dollar as the quote currency, each price movement will be equal to either $10 or profits or losses;
- In order to use leverage with a broker, a trader must have a certain minimum amount of capital in his account. This is called a margin;
- Different brokers offer different leverages, with 100:1 being most common. This means a trader can buy a standard lot for only $1,000;
- When traders use leverage and forget about capital management, they risk losing all of their trading capital;
- Leverage increases transaction costs for each transaction.