In the Forex Market, How Does Leverage Work?

The use of borrowed money (referred to as capital) to invest in a currency, stock, or investment is known as leverage. In forex trading, the concept of leverage is fairly frequent. Investors can trade greater positions in a currency by borrowing money from a broker. As a result, leverage multiplies the gains from favorable currency exchange rate changes. However, leverage is a two-edged sword, as it can compound losses as well. To minimize forex losses, forex traders must learn how to manage leverage and use risk management tactics.

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IMPORTANT TAKEAWAYS

  • In forex trading, leverage, or the use of borrowed money to invest, is highly common.
  • Investors can trade greater positions in a currency by borrowing money from a broker. However, leverage is a two-edged sword, as it can compound losses as well.
  • Many brokers demand that a particular percentage of trade be held in cash as collateral, which can be larger for certain currencies.

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Understanding Leverage in the Forex Market

The forex market is the world’s largest, with daily currency exchanges totaling more than $5 trillion. Buying and selling currency exchange rates to move the rate in the trader’s favor is what forex trading is all about. The broker quotes or displays currency rates as bid and ask prices. The ask price is quoted to an investor who wants to go long or buy a currency, and the bid price is quoted to an investor who wants to sell a currency.

 An investor might, for example, buy the euro against the US dollar (EUR/USD) in the hopes that the exchange rate will rise. The trader would buy the EUR/USD at $1.10 on the ask. If the rate moved in the trader’s favor, he would close the position a few hours later by selling the same amount of EUR/USD to the broker at the bid price. The profit (or loss) on the trade would be the difference between the buy and sell exchange rates.

To increase the profit from forex trading, investors employ leverage. The forex market provides investors with some of the highest leverage available. The term “leverage” refers to a loan given by a broker to an investor.

The forex account of the trader is set up to allow trading on margin or with borrowed cash. Some brokers may restrict the amount of leverage utilized by rookie traders at first. Traders can usually modify the amount or size of the deal based on the leverage they want. However, the broker will want the initial margin, which is a proportion of the trade’s notional amount held in the account as cash.

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Different Leverage Ratios

Depending on the size of the trade, each broker may require a different initial margin. If an investor purchases $100,000 worth of EUR/USD, they may be forced to retain $1,000 in the margin in their account. To put it another way, the required margin would be 1% ($1,000 / $100,000).

The leverage ratio indicates how much the trade size is magnified due to the broker’s margin. The leverage ratio for the deal, using the initial margin example above, would be 100:1 ($100,000 / $1,000). In other words, an investor can trade $100,000 in a currency pair for a $1,000 investment.

Leverage is usually given in a fixed amount that can vary with different brokers. Each broker gives out leverage based on its rules and regulations. The amounts are typically 50:1, 100:1, 200:1, and 400:1.

  • 50:1: Fifty-to-one leverage means that for every $1 you have in your account, you can place a trade worth up to $50. As an example, if you deposited $400, you would be able to trade amounts up to $20,000 on the market.
  • 100:1: One-hundred-to-one leverage means that for every you have in your account, you can place a trade worth up to $100. This ratio is a typical amount of leverage offered on a standard lot account. The typical $1,000 minimum deposit for a standard account would give you the ability to control $100,000.
  • 200:1: Two-hundred-to-one leverage means that for every $1 you have in your account, you can place a trade worth up to $200. The 200:1 ratio is a typical amount of leverage offered on a mini lot account. The typical minimum deposit on such an account is around $400, with which you can trade up to $80,000.
  • 400:1: Four-hundred-to-one leverage means that for every $1 you have in your account, you can place a trade worth $400. Some brokers offer 400:1 on mini lot accounts but beware of any broker who offers this type of leverage for a small account. Anyone who makes a $300 deposit into a forex account and tries to trade with 400:1 leverage could be wiped out in a matter of minutes.

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What is margin?

Let’s go back to the earlier example:

In forex, to control a $100,000 position, your broker will set aside $1,000 from your account. Your leverage, which is expressed in ratios, is now 100:1. You’re now controlling $100,000 with $1,000. The $1,000 deposit is the “margin” you had to give in order to use leverage.

Margin is the amount of money needed to open a position with your broker. It is usually expressed as a percentage of the full amount of the position. For example, most forex brokers say they require 2%, 1%, 0.5% or 0.25% margin. Based on the margin required by your broker, you can calculate the maximum leverage you can wield with your trading account.

MARGIN REQUIREMENTMAXIMUM LEVERAGE
5.00%20:1
3.00%33:1
2.00%50:1
1.00%100:1
0.50%200:1
0.25%400:1

As the table above shows, the smaller the margin requirement, the more leverage that can be employed on each trade. However, depending on the currency being traded, a broker may impose higher margin requirements. The exchange rate between the British pound and the Japanese yen, for example, can be highly volatile, meaning that it can move wildly, resulting in huge swings in the rate. For more volatile currencies and during turbulent trading periods, a broker may require more money kept as collateral (i.e. 5%).

Margin requirement: We just talked about it earlier. It is the amount of money your broker requires you to open a position. It is expressed in percentages.

Account balance: This is just another phrase for your trading capital. It’s the total amount of money you have in your trading account.

Used margin: The amount of money that your broker has “locked up” to keep your current positions open. While this money is still yours, you can’t touch it until your broker gives it back to you either when you manually close your current positions or when a position is automatically closed by your broker.

Usable margin: This is the money in your account that is available to open new positions.

Margin call: You get this when the amount of money in your account cannot cover your possible loss. It happens when your equity falls below your used margin. If a margin call occurs, your broker will ask you to deposit more money in your account. If you don’t, some or all open positions will be closed by the broker at the market price.

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Conclusion

As you’ve been enlightened on the concepts of leverage and margin with relatable examples.

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