Introduction to Forex Leverage, Margin and Margin Calls

One of the reasons why so many people are drawn to forex trading relative to other financial instruments, is that you can typically get a much higher leverage with forex than you would with stocks. While the term leverage has been heard by many traders, few know its meaning, how the leverage works and how it can directly impact their bottom line. The concept of using money from other people to enter a transaction may also refer to the forex markets. In this article, we will discuss the advantages of trading with borrowed capital and explore why using leverage in your forex trading strategy can be a double-edged sword.

What is Leverage ?

Leverage comes from using borrowed money as a source of funding when investing in expanding the asset base of the company and growing returns on venture capital. Leverage is an investment approach to use borrowed money — specifically, the use of different financial instruments or borrowed capital — to optimise the potential return on an investment. In addition, leverage can refer to the amount of debt a company uses to finance assets. When a company, property or investment is referred to as highly leveraged, that means the item has more debt than equity.

Leverage is the use of debt to fund an investment or project. The consequence is a calculation of potential project returns. Simultaneously, leverage may also increase the potential downside risk in the event that the investment does not pan out. The leverage principle is utilised by both companies and investors. Investors are using leverage substantially to increase the returns that an investment can provide.

They maximise their investments through the use of various instruments including options, futures, and margin accounts and these constitute the leverage businesses can use to fund their assets. In other words, businesses can employ debt financing to invest in business processes in an attempt to increase the shareholder value instead of selling stocks to raise capital.

Investors who are uncomfortable actively using leverage have a range of ways to control leverages indirectly. In the usual course of their business, they may invest in businesses that use equity to fund or expand operations, without raising their outlay.

How Does Leverage Work in Forex Trading ?

In forex, investors use leverage to take advantage of volatility in exchange rates between two different countries. The leverage attainable on the forex market is one of the strongest investors can get. Leverage is effectively caused by a loan provided by the broker to an investor; the broker manages the forex account of the investor or trader.

When a trader wants to sell in the forex market, a forex broker must first open a margin account. The amount of leverage offered is usually either 50:1, 100:1 or 200:1, depending on the broker and the scale of the position the investor is selling. What do you mean by that? A 50:1 leverage ratio means that the trader’s minimum margin requirement is 1/50 = 2%. A ratio of 100:1 means the dealer must have at least 1/100 = 1% of the total trade value accessible as cash in the trading account, etc. Standard trading is done on 100,000 units of currency, so the leverage offered typically is 50:1 or 100:1 for a transaction of this size. The 200:1 leverage is commonly used for $50,000 or less positions.

In order to swap $100,000 in currency with a 1% margin, an investor would only have to deposit $1,000 into his or her margin account. The leverage given on such a transaction is 100:1. The leverage of this size is substantially greater than the commonly offered 2:1 leverage on equities and the 15:1 leverage on the futures market.

While the leverage of 100:1 may seem incredibly high, the risk is significantly lower when you remember that currency prices usually adjust by less than 1% during intraday trading. If currencies were as fluctuating as equities, brokers will not be able to have the same leverage.

The leverage is usually as high as 100:1 in the foreign exchange markets. That means you can trade up to $100,000 in value for every $1,000 you have in your account. Many traders believe that the reason forex market makers are offering such a high leverage is that leverage is a risk feature. They know that if the account is managed properly, the risk will also be very manageable or they would not be providing the leverage as well.

As spot cash forex markets are so liquid and broad, it’s much easier to exit and sell at the level you desire than in other less liquid markets. We track currency fluctuations in trading pipes, which is the slightest price currency shift, depending on the currency pair. These movements are just one-cent fractions.

That is why currency purchases have to be carried out in considerable amounts, enabling such infinitesimal price movements to be transformed into greater profit when magnified by leverage use. When you manage a sum like $100,000, small adjustments in the price of the currency will result in significant gains or losses.

How to Calculate Leverage

Forex trading provides a high leverage in the sense that a trader can create – and manage – a huge amount of money for an initial margin requirement.

In order to calculate a margin-based leverage, divide the total value of the transaction by the amount of margin that you are required to set:

Margin-based leverage = Total transaction value / Margin needed

Nonetheless, leverage that is margin-based does not always affect risk and if a trader is required to put up 1% or 2% of the value of the transaction as margin, it may not affect their gains or losses. The real leverage is the better indicator of profit and loss, not a margin-based leverage. Simply divide the total face value of your open positions by your trading capital to determine the leverage you are actually using: Real Leverage = Total Value of Deal / Total Trading Capital

This also means that the margin-based leverage exceeds the actual real leverage of a trader. As most traders do not use all of their accounts as spreads for each of their transactions, their real leverage tends to vary from their margin-based leverage. A trader shouldn’t use all his or her available margin automatically. A trader should use leverage only if they have a clear advantage. Once the number of pips is determined, the potential resource loss can be estimated.

As a rule, that loss should never exceed 3% of trading capital. If a position is leveraged to the point that, say, 30% of trading capital could be the potential loss, the calculation would reduce leverage. Traders will have their own level of expertise and risk and may opt to deviate from the 3% general guideline.

What are the Risks of Excessive Real Leverage in Forex Trading ?

Leverage is a dual-edged sword, because in reality it has the ability to increase the amount of your gains or losses. The higher the amount of leverage you put on the money, the higher the chance you’ll expect. Remember that this risk is not specifically related to leverage that is margin-based, although if a trader is not cautious, it can affect it.

While the ability to make significant profits through the use of leverage is important, leverage may also operate against investors. For instance, if the currency that underlies one of your trades, shifts in the opposite direction of what you thought would happen, leverage would significantly intensify the potential loss. Forex traders typically adopt a strict trading style to prevent a disaster that involves the employment of limit orders and stop orders designed to mitigate potential losses.

What are the Pros and Cons of Leverage in Forex Trading ?

With a greater market position, based on the volume of leverage, you will increase your profit potential. It can however be both advantageous and risky, because leverage helps you to:

  •       Increase the capacity of your securities, thereby improving your overall market benefit
  •       Create greater losses than your initial capital, if the value of its market position falls below its original market entry price.

In addition, some brokers provide high-leverage ratios of more than 400:1, which is believed to be extremely unsafe as it can result in huge losses. Some regulatory authorities will therefore only provide lower ratios.

What is Margin ?

Margin represents the amount of money that you are supposed to invest to cover the leveraging credit risk. Yet you will be looking at your limited margin most of the time. This is your account balance figure, with which you can trade. Brokers will usually express expectations for margins as a percentage of the trader’s position.

However, the margin value is not absolute, since it fluctuates according to the stock holding interest of the trader. The broker retains the percentage room when you open a new contract. If you open too many trades at any given time, you will be constrained in opening new ones since there will be no margin remaining in the trading account.

What are Margin Calls ?

Margin calls arise if the amount of money in your account is less than the percentage of the broker’s profit. You will receive a request from the broker to fuel your account until the percentage of the necessary margin is reached. Alternatively, certain of the places can be liquidated to protect the margin. Note that your broker may close some or all of your positions at their own market price if you fail to act in time.

What is the Relationship Between Leverage and Margin ?

Margin and flexibility go hand-in-hand since you can’t trade leverage without margin. Leverage and margin both refer to the same thing, but differently. Although interwoven — because both require borrowing— leverage and margin are not equivalent.  A margin account allows you to borrow from a broker to purchase shares, options, or futures contracts at a fixed interest rate in anticipation of significantly higher returns. Use leverage to build margin.

How to Use Leverage and Margin

To begin to use the leverage and margin efficiently, you must first find out your total equity. In forex trading, in relation to the losses and profits unrealised and losses in your open positions, equity refers to the total amount of money available in your trading account. Because your overall equity also depends on your open positions, it is constantly changing due to market price changes. Next, you’ll need to work out your available margin.

Your available margin can usually depend on what other open positions are you in. You go on to do your first service. You place the trade, and your requisite margin is now your margin of use. If the market price of a currency pair changes when your trade is still active, the trade value often changes. This affects your margin needed, your profits or losses, and the margin available to you.

Losses and benefits are referred to as floating profits and losses which are still in motion. These must always be considered, as they contribute to the margin available to you. In order to calculate the new floating profit or losses, you will figure out how much pips have increased the price of the exchange. Their open positions constantly affect your available margin. As such, it is recommended that you never use all of your available margin at once, as one bad trade could wipe your account clean.

Who Should Use Leverage and Margin ?

While using leverage properly can maximise the income, it’s really a double-edged sword, because you can lose more than you’ve invested. In reality, however, during your trading career you will almost certainly use leverage and margin. This is because forex trading can’t be done on a retail scale without taking a massive amount of capital without leveraging. What’s more, even if you had an immense amount of capital you wouldn’t want to put everything on the line. One way to manage your risk is never to overtrade while trading.

Overtrading happens when too many trades are opened by a trader simultaneously in the same direction on margin. Another way is to deal only with the best forex brokers. Choosing a reputable, high-quality broker will give you access to responsible leverage rates. You won’t be forced to place riskier trades with these brokers than you would like, and your accessible margin will still be displayed clearly and immediately updated.

We suggest you first compare top brokers to find one that fits your trading style and budget to begin forex trading with margin and leverage. Beginner traders will look for one that provides low leverage and a good demo account, as this helps you to practice free trading before plunging into a real-money situation.

Finally

There’s no need to fear control once you’ve learned how to manage it. The only way you can never use the advantage is to take a hands-off approach to your trades. Then the power with good management can be used effectively and profitably. Like any sharp instrument, the leverage has to be carefully handled. Once you learn to do so, you have no reason to worry.

Smaller quantities of real leverage added to each trade provide more breathing space by placing a broader but fair stop and preventing greater capital loss. If it goes against you, a highly leveraged trade can easily deplete your trading account, as you are going to rack up bigger losses due to the larger lot sizes. Keep in mind that the leverage is totally adjustable and can be customised to the needs of each trader.

The leverage concept is used by both investors and businesses. Investors are using leverage to increase the gains that an investment can provide substantially. They leverage their investments through the use of various instruments including options, futures, and margin accounts. Businesses can use leverage to finance their assets. In other words, companies may use debt financing to invest in company operations in an effort to increase the shareholder interest instead of selling stocks to raise capital.

FAQ's

No, however linked, they are not the same. Leverage is the credit that a broker is supplying you with to support large positions. On the other hand, margin is the proportion of the total trade value that you will give the broker. So, for example, if you decided to hold a $100,000 position, and the broker gave you a 100:1 leverage, you would need a margin of $1,000.

In forex trading there is no best leverage as it all rests on your trading experience, your overall market conditions and equity. Greater leverage ratios are associated with higher risks, while smaller leverage ratios limit the opportunities to make profit. Novice traders should stick to leveraging ratios no greater than 50:1, since this minimises the chance of wiping out your account in a single wrong trade

Trading without leverage is theoretically possible, but this is not a practical choice for most traders. Profitable trading without leverage demands a large amount of assets. If you try to trade with a limited amount of capital without leverage, you’d notice that your profit-making prospects are so limited that the risk just isn’t worth it.

Leverage is having the ability to use zero or very little of your own resources and borrow the rest to manage a large amount of money. Using leverage enables traders to trade in larger sizes allowing higher potential returns (and losses) than would have been possible otherwise. Comprehending how to use leverage properly is important.

In theory, margin is collateral for opening and retaining a position. You’re needed to make a payment into your margin account before you place a trade. The amount depends on the percentages of your broker’s margin required to trade leveraged positions.

Multiple economic and political factors affect currency prices, such as economic growth, interest rates, inflation and political stability. Governments may also try to influence the value of their currencies directly, either by increasing their domestic currency supply or by buying up their domestic currency on the market in an effort to raise the price in an attempt to lower the price. That is known as intervention by the central bank.

Risk is the amount of money you or the lender are putting at risk. But the sum of leverage and margin impacts risk in forex trading. The degree of leverage also affects your risk, the greater the leverage, the greater the loss you stand to suffer. In forex, a trader often has a position on a high leverage that may not be a big position, but because it is losing a lot of money, it can still threaten the entire balance. On the part of the investor, risk management is very important to ensure a losing position is closed before it takes off too much equity.