Forex Leverage and Margin Explained
- April 12, 2018
- Will Turner
The foreign exchange market, otherwise known as forex or FX, attracts numerous investors each day. The main reason is that forex trade offers a great opportunity to gain a significant return on investment (ROI), by trading in currencies. That being said, trillions of dollars worth of investments are exchanged each day on the forex market.
However, no matter if you’re a beginner or an expert at forex trading you need to understand the concept of forex leverage and forex margin, in order to make your investments most profitable. Here’s a detailed explanation of forex leverage and margin that will help you better understand these terms.
What’s forex leverage?
Simply put, forex leverage is a way for investors to boost their trade using only a small part of their own assets and borrowing the capital from their forex brokers. That means that an investor can trade a large amount of money using very little of their own initial capital. As a result, investors can maximize their potential profits on currency exchange.
However, as beneficial as leverage can be, it’s also considered a double-edged sword. The main reason is that you can lose large amounts of money if the trade doesn’t go as you expected. That’s why it’s important to have a well-developed risk management plan before you start using forex leverage.
What’s a forex margin?
Many investors that are new to the forex market oftentimes confuse what a margin really is. They believe it’s a fee imposed by brokers to keep a trade open. However, a margin is far from a fee, it’s a form of a “good faith” deposit that trades put up as collateral to keep a position or multiple trade positions open and gain forex leverage from brokers.
Every trader must open a trading account with their broker and place an initial margin amount on their account so that they can trade currencies. Brokers use these margin amounts to maintain your trade position and cover any losses. In layman terms, a margin is a percentage required to make a trade open and it’s determined by the size of the trade.
Forex leverage example
As mentioned before, forex leverage is a form of a loan that’s given to traders by brokers. What’s more, forex leverage doesn’t involve any interests. The way leverage works is that you get a chance to trade with more currency units than you can afford. The type of leverage you’ll get depends on the account type you have. That’s why it’s important to check in with your forex broker and determine what type of leverage you can work with. For instance, the leverage amounts are usually 20:1, 50:1, 100:1, 200:1 and 400:1.
However, there may be restrictions on specific currency pairs and country-related regulations. Furthermore, the leverage amount determines how many positions you’re allowed to control. As an example, if your broker leveraged you 20:1 and you set aside $1,000 into your account, you’re allowed to control $20,000 (20x 1,000). Also, if you’re leveraged 100:1 you’re allowed to control $100,000. It’s important to understand that only a $1,000 is your capital and the rest is covered by the broker.
Therefore, if your 100:1 investment controlled by $1,000 increases to $101,000 you gain $1,000 worth of profits, which is a 100% return on investment. If the entire capital was your own, you’d only gain a 1% ROI. On the other hand, if your investment falls to $99,000 you’ll lose $1,000 which is also a 100% loss due to leverage. That’s why forex leverage is considered to be a double-edged sword. In short, forex leverage can help maximize profits, but it can also cost you your entire investment, if not more.
Forex margin example
Unlike forex leverage that’s expressed in ratios, forex margins are expressed in percentages. Since brokers don’t give credit, you’re required to deposit a margin amount as collateral on your trading account. Margins that are required by brokers are usually 5%, 2%, 1%, 0.5% and 0.25%. The margin required also helps calculate leverage ratio.
For instance, a standard of $100,000 units controlled by $1,000 capital means your broker leverages your 100:1. In this case, the $1,000 on your account is the margin amount, which means that the broker requires 1% for the margin. Therefore, if your margin is 0.25% your leverage is 400:1. If it’s 0.5% then leverage is 200:1 and so on.
Once the margin is set, your broker will pool your deposit alongside everyone else’s margin deposits that are trading on the same pair as you are. That way, they create a “super margin deposit” which they use to place trades inside their own interbank network. If your investment turns profitable you’ll have funds available on your account margin and you’ll have more usable margin to make new trades. However, if you get a margin call, it means your investment fell below your margin used. Now, you’ve lost your investment and may even be in dept to your broker.
Forex margin and forex leverage are equally important to understand, so that you can effectively calculate the number of trades with your current account balance. You must also understand both the benefits and the risks that come from using leverage. That way, you’ll be able to maximize your profits and avoid potential pitfalls.