Forex Leverage & Margin

Forex Leverage

If so many traders are interested in trading the forex market, it’s mostly because of the industry’s high leverage capacities. Using leverage, traders can significantly increase the potential profit on an investment. Leverage trading, or Margin Trading, also means that traders don’t have to deposit the full value of their positions and can thus hold positions that are worth much more than their account capital (up to 200 times).

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Forex provides much more leverage than other financial markets such as stocks or futures for instance. Unlike active stocks whose prices may move from 5% to 10% a day, the volatility of currencies rarely exceeds 1% on a daily basis. In the world of forex, a one cent move (around 100 pips) in a currency value is actually considered a significant fluctuation. When trading forex, leverage is thus a way to earn higher returns on relatively small market movements. Trading currencies with a few thousand dollars and without leverage does not make much sense since return would be insignificant.

Example:

• A trader has $1.000 in his account.
• He buys one lot ($100,000) of GBP/USD at the price of 1.9750 with the maximum 200:1 leverage. The margin used is $500.
• If the market moves in the trader’s favor up to 1.9850 (a 100-pip move), he makes a profit of $1,000 (100 pips x $10 per pip). His capital is now double his initial account capital ($1,000 initial capital + $1,000 gain). He made a 200% gain on his $500 margin and a $100% return on his $1,000 account.
• If the market moves against the trader’s position by 20 pips, down to 1.9730, the trader loses $200 (20 pips x $10 per pip). His capital is now down to $800 ($1,000 - $200).
• If the market moves against the trader’s position, let’s say 60 pips down to 1.9690, his position would have been automatically closed due to what is known as margin call. This means that the moment his account capital dropped below the $500 margin requirement, the position closes to avoid bigger losses. In this case, the trader has lost around $500, or 50% of his initial equity. He still holds $500 in his account.

Leverage and Margin

As you saw in the example above, leverage and margin are interconnected since you can use margin to create leverage and since leverage utilizes margin. In forex, when you leverage a position, you put down collateral, also known as margin, to enter a position whose value is much greater than this collateral. We offers several leverage options, up to 200 to 1. This means that with a $1,000, you can purchase $200,000 worth of a currency. However, although leverage is a great tool to increase your buying power and use less capital to trade, it also comes with great risk. If the market moves against the trader’s position, the loss sustained by the trader will be far more significant that it would’ve been without leverage. For this reason, some traders prefer to test the market sentiment by first applying small leverage and opening small positions. If they see that they were right and that the market is moving in their favor, they hurry to increase leverage for maximized profits.

Traders must remember that in forex, leverage is a double-edged sword: while it can multiply your gain potential exponentially, it can equally magnify your loss potential. We therefore recommend that traders new to the forex market start trading with small leverage options.

One last word about leverage: like with margin, leverage can also be utilized with other financial instruments such as futures, CFD and Options. For example, if a trader wants to invest $2,000, he could invest it in 20 shares of a given stock whose price is $100 per share, but he could also invest it in ten options contracts. That way, he would control 100 shares instead of owning just 10 shares.

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