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What is leverage?
One of the main attractions to trade forex is big leverage and allows currency traders to borrow money and use that money to to profit from the fluctuations in exchange rates between two currencies. The leverage usable in forex trading is one of the highest that traders can obtain. Leveraged trading means that you are not required to pay the full value of the trading position but only small part of it.
Because of the big leverage in foreign exchange, traders are able to make large investments without a huge amount of trading capital, whereas in other financial markets such as the stock market, investors would have to pay 50% of the full amount for each share they were investing in.
Forex provides much more leverage than stocks or futures, allowing positions to be leveraged up to 100:1 or even 200:1 depending on the forex broker and the size of the position taken. This means that if a currency trader wanted to buy a “lot” worth $100,000, with 100:1 leverage, the trader only has to put up $1,000 of his own money into his margin account! With leverage, you can achieve higher returns on a smaller market movement.
What is margin?
In forex, margin is the minimum required balance to place a trade and is a performance bond, or good faith deposit, to ensure the currency trader against trading losses or falling into a negative balance. This deposit, called margin, is typically 1% or .5% of the value of the position. The margin requirement allows traders to hold a position much larger than the account value.
For example, if you want to purchase $200,000 of EUR/USD at 200:1 leverage, the amount of money required is .5%, or $1000. The other $199,000 is collateralized with your remaining account balance. You pay no interest.
What's the relationship between margin and leverage?
Leverage and margin are direct related in the way mentioned above. The amount of leverage a forex broker gives to a trader defines the amount of margin that the client will have to commit in order to take a position in the market. For example, when leverage is 100:4, the “4” in the leverage ratio signifies the amount of capital the customer has invested of his own money, which is also known as the margin.
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Risks of leveraging your money
Without the use of risk management, a high degree of leverage can lead to large losses as well as gains. Risk management tools when trading forex includes the use of limit, stop-loss and trailing-stop orders.
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What is a margin call?
A forex broker will close your open position(s) immediately if the equity in your trading account drops below the margin requirement. This to prevent you from negative account balances.
For example:
Assume you have a trading account with $20,000 and margin requirement is set to 100:1. Without any open positions, your usable margin is $20,000.
Getting a margin call scenario:
You use $15,000 to buy 15 lots of EUR/USD, you now have $5,000 of usable margin left. This means that you are allowed to lose $5,000 on the open postion before you are under the margin requirement.
Formula: Usable Margin = Equity – Used Margin
In the event EUR/USD moves in the opposite direction of what you believed would happen and you don't close your position to prevent you from further losses, the broker will automatically close it when your usable margin is $0.
You would have lost $5,000 on this trade and the EUR/USD only moved 33 pips against you.($5,000 usable margin /(15 lots x $10/pip))!
Conclusion
Leverage is a double-edge sword and can lead to large losses as well as gains, trading big leverage can be fun because it dramatically increases your buying power BUT in the event a trade moves in the opposite direction of what you believed would happen, it can cost you a lot money. Use risk management tools such as limit, and stop-loss orders to prevent you from getting margin calls. |
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