Leverage is when an increased volume of capital is borrowed using a smaller amount in order to invest and magnify potential gains. However leverage is considered a ‘double edged sword’. Not only is there a possibility of gaining increased profitability, but there is also a risk of greater losses. A forex trader will need to use sophisticated risk management in order to tackle passed the nuisances of the ‘double edged sword’. Traders are given the opportunity to control huge amounts of money using very little of their own and in a sense simply borrowing it from their broker. Depending on the level of forex leverage your trading account is opened in, you can have access to a large chunk of capital with very little outlay needed. Say for instance there is something worth $100,000 and you pay $10,000 and the loan you borrow from your broker is $90, 000, the remaining capital needed is what you gain from the leverage.
Imagine you have $5,000 in your trading account, trading on 100:1 leverage gives you the power of $500,000. As leverages are determined in ratios, the leverage you have gained is 100:1. If the value of your open trade moves up to $501,000, you gain 100% of the profit, which will be $1,000. The leverage in this situation gives you the ability to earn 100 times more than the capital you put down.
Now on the other hand, consider that you have a 1:1 leverage where you have to come up with the $500,000. A 1:1 leverage means that your investment of $500,000 can too increase in value to $501,000, but you are risking your $500,000 to gain your $1,000 profit. Your profit here will only be 0.2% as well. The reason why leverage and forex trading is so popular is you are not required to have $500,000 capital to invest. A 1:1 leverage is not at all attractive when forex trading can give you 100:1 leverage.
It works the other way however…If your $500,000 trade which you opened with a $5,000 capital at 100:1 leverage dropped to $495,000, you will lose your $5000 investment. As likely as you are to earn increased profits with a 100:1 leverage, you are just as likely to lose the equivalent amount if your trading plan isn’t up to scratch.
There are several terms used to distinguish different types of margins in a Forex trading platform. The deposit given to the broker by the trader is known as a MARGIN. Margins are required in order to use leverage. A broker demands this margin so that the opened position is maintained and sustained. The amount of margin demanded varies from broker to broker. A trader will offer the collateral in order to ensure and guard that his broker is not under threat of any credit risk.
Each and every trader’s margins are combined so that a large margin deposit is created and then used to position trades within the interbank network. With reference to the above leverage example, the margin is the $5,000 deposit given. Forex brokers will state how much margin they require off a trader wanting to open a position. A forex margin is articulated through percentages, ranging from 1% to 25%. By considering the percentages stated by a broker, a trader will be able to estimate the maximum leverage that could be used with their trading account. For instance, a 2% margin requirement represents a leverage of 50:1 while 0.50% represents a leverage of 200:1.
ACCOUNT MARGIN defines the amount of funds a trader possesses in his trading account. In this margin account a trader is investing with his broker’s capital and during leverage he is risking both gains and losses.
USEABLE MARGIN is the funds accessible in the trader’s account that are optioned for opening new positions.
A MARGIN CALL will occur when open losing positions are extremely decreased further than the useable margin levels. This margin call means that the broker will close all or several open positions at the market price.
Finally, when a trader closes a current position or obtains a margin call, the broker is obliged to give back the money they ‘locked up’ to ensure that the current position was open. USED MARGIN is the amount of money that was reserved.
Leverage, Margin & Risk
As a newcomer to the Forex industry, it is rather difficult to understand every term and technical aspect straight away. Throughout this article, we will aid you in gathering the basic knowledge of Forex trading to be able to start your trading career.
How Forex Leverage Works
When a trader opens a Forex trading account with a broker, they need to be aware that the movement of the currency rates are extremely frequent. Generally speaking this means that most Forex trades involve very small differences in price, for example a price difference of 1 cent. This is where the availability of leverage turns these small price changes into possible big money earners.
In many other financial markets trading with such small amounts will mean the time in making a gainful profit will require a much larger initial investment. Fortunately there is the availability of high leverage in Forex trading. Leverage is used by traders to increase their chance of profit potential. Even with a small initial deposit, leverage enables a trader to gain a quicker return on his/her investment.
Leverage trading involves creating a rate the trader will use for every dollar in his/her account. The funds placed for a trade is immediately at risk, formally known as ‘margin’.
A trader opens a Forex account at their selected broker. He/she decides to trade the currency pair EUR/USD. He/she is buying into the EURO in exchange for selling the US DOLLAR. The price is 1.1000 and the contract value is EUR 100,000. Any trader in this situation aims to profit once they close this contract. If this is successful in happening, the rate would perhaps increase to 1.2000 and the trader will profit. For every Euro the trader made a profit of 1 US cent. As a total the profit earned would be $1,000- 100,000 x 1 cent.
Now here is where the leverage comes in. The trader will not need the full EUR 100,000 to open this contract. He/she will be required to use leverage and risk perhaps 1:100 of the contract value. The trader needs $1,000 for a contract of 100,000. Therefore, if there was a loss and the value of the entire contract decreased to 99,000 then the deal would be immediately closed.
Leverage is a ‘double-edged sword’. There is the opportunity to win however there is also the equal opportunity to lose. A trader has more money to use for his/her trading executions than that in his/her account when referring to leverage. The trader uses what he/she currently owns to increase the amount he/she can trade and thereafter increase the potential profit if the trade is successful. This is how leverage works as an advantage for traders. In contrast however, leverage can work against the trader when there is a loss. If there is a high leverage, the trader is risking a quick route in automatically closing the deal because the currency pair involved is moving against the trader’s investment. This is why leverage also entails some risk. Every trader is advised not to risk more than he/she can accept to lose. Previously, we mentioned the term ‘margin’. Here is an easier and more detailed explanation of ‘margin’ and how it is used in Forex trading.
Earlier we stated that margin is the funds placed for a trade that can be immediately at risk. Margin is the amount the trader places in the Forex contract that is opened. With the use of margin, a trader is given the opportunity to invest in a market where the smallest trade he/she makes is already high. Margin trading can increase one’s profit but can also increase loss. A trader is required to pay if they at any point lose funds during a trade. Keeping this in mind, traders place money into an account and this account is used to cover any losses that may take place. This is known as ‘minimum security’. Your margin is essentially your investment. You have to invest a margin of $1,000 to be trading with $100,000. This is of course at a leverage of 1:100. So as you know, there are plenty of ways to lose profit and experience risk in the Forex market.
There are however a couple of methods to limit the amount of risk during trading.
Stop-Loss rates: A trader selects a rate that is the lowest he/she wants to go. Now, if the market ends up reaching that rate, the trade will be automatically stopped. This helps limit the risk of losses and the trader will not lose more than he/she is prepared to. This is an advantage to traders because they are in some way, in control of their investments.
Take-Profit rate: This is similar to the Stop-Loss rate. The deal will close once the profit rate the trader selected is reached. The set rates can be altered at any time whilst the deal is open. This form of risk control allows the trader to control his/her trading without the need to regularly observe the position.
Ironically, these risk control methods also entail a disadvantage. It is not a full guarantee that the pre-set rates are consistently going to work. This is because market conditions sometimes change and this affects the Forex market. These conditions can alter so quick that traders currently in a trade will be prevented from executing pre-set rates. Unfortunately, the environment will be out of the trader’s control.
Of course every business involves risk; however in order to battle past these risks as much as you can it is advised to understand every aspect and application of Forex. We hope that by reading the above facts, you have learnt ways to decrease risk and to understand how to properly use leverage and margin. Traders are less prone to fail when there has been sufficient studying, research and practice undertaken beforehand.