What is leverage? What is a margin?
This lesson will cover the following
- The concept of leverage
- Characteristics of margin
What is leverage? What is a margin?
When it comes to Forex trading one should take into consideration two extremely vital concepts – the leverage and the margin. This is so, as these concepts could easily cause worries, in case they are not used appropriately. The terms “leverage” and “margin” are related to one and the same idea, but however, in different cases.
What is leverage?
When we refer to leverage, we usually mean the use of borrowed capital in order to expand the potential return of an investment we are intending to make. It favors both the investor and the firm to invest or operate. What is worth noting, however, is that leverage is always related with a higher level of risk. If an investor decides to rely on leverage in order to invest and the investment moves against the investor, his/her losses may appear to be far larger than they would have been, if the investment had not been leveraged. Therefore, it is useful to say that leverage amplifies both profits and losses.
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Leverage is usually presented with the use of a ratio, for instance, 1:100 or 1:500. This relation states that for every $1 the investor deposits into his/her account, he/she is able to enter into trades worth $100 or $500. With the help of leverage, investors do not necessarily need to have thousands of US dollars in their possession in order to make trades in the market, where only large corporations or institutions could afford to participate several years ago.
In Forex extremely high levels of leverage are to be seen, as trading is executed in the market with the largest daily trading volume of all types of financial markets. Brokers allow their customers to use high level of leverage, as it is relatively easy to enter into and to get out of a trade (liquidity). Given the fact that liquidity is that high, traders are able to manage their losing positions in a much easier way.
Currency trading is usually exercised in “contracts” for a standard amount of units called lots. Each lot is worth 100,000 units of a particular currency. In case a trader uses the US dollar for denomination, if he/she enters into a position with one standard lot, then he/she is purchasing or selling 100,000 units of that currency.
In Forex, in case a trader has $1,000 dollars, while controlling an entire $100,000 standard lot, then his/her leverage is 1:100. The trader can make deals up to the amount of $100,000, while only owning $1,000 of it.
Now, let us imagine that the trader had the entire $100,000 in his/her possession and his/her account increases in value by $1000. The trader has now expanded his/her bank roll by 1%. That is what is known as a 1:1 leverage. In Forex that is not the case, as leverage is created, so that traders do not need to own large amounts of money in order to engage in market trading. The trader uses leverage of 1:100 and the $1,000 profit he/she obtained, actually doubled his/her deposit. Looks like a good deal, right?
However, there is another scenario. Let us imagine that instead of increasing by $1,000, the traders account decreases by $1,000. Using higher levels of leverage boosts ones purchasing power, but also ones exposure to risk. That is why in the Forex industry, leverage is often referred to as a double edged sword.
What is a margin?
If a trader is willing to enter into trades with the use of money he/she borrowed, then he/she will need to make a deposit, that represents a certain portion of the actual value of the trade. This deposit is referred to as a requirement for margin or a good faith deposit. What is specific here is, that in most cases investors will be able to withdraw the entire amount of the deposit, if they decide to get out of the trade.
Now is the time to reveal another crucial moment in margin trading. If the strategy a trader follows, does not work and the trader starts to lose money, he/she may eventually come to the point, when a certain portion of the deposit may be lost. The trader experiences the so called margin call. This is a situation, when their margin falls below 50% (below the obligatory maintenance margin). In case a margin call occurs, the broker requires of the customer to deposit additional amount of money, so that the account is restored to or above the minimum maintenance margin, which allows the client to continue trading. This is an insurance for the broker that the trader would eventually pay his/her debt.
Let us look again at the example we provide earlier. In Forex, a trader may enter into trades up to $100,000 with a mere $1,000 set aside. The leverage in this case is 1:100. The $1,000 that the trader deposited into his/her account is considered as the initial margin. This is what the trader had to give up in order to engage in the market.
Remember, your margin is the money you give to your broker as a deposit of good faith. The broker requires these margins from everyone and puts them together in order to make huge trades on the inter-bank network. The actual profit or loss you register in the market is dependent on the size of the trade you entered into, and not on the amount of margin required.