What do leverage and margin mean in Forex?
25 Oct 2018
Understanding what the concepts of leverage and margin mean is necessary for those who are just entering the world of Forex investments, for the most experienced and for those who have chosen to trade in other financial markets.
New users are often eager to start trading, without first taking into account the importance and impact that the two factors mentioned above could have on their growth and future success.
To invest and trade in currency markets, it is necessary to study in detail how leverage and margin work. That is why, in this article, we will explain everything about them, including how they work so you can put them into practice as soon as possible.
What Is Leverage?
The term "leverage" refers to the ability to trade or trade with a large amount of money without using your own money (or using a small amount of it). That is, it is done through a loan.
Leverage offers users an opportunity to take risks in the market, increasing the amount of real money they have in their respective accounts in order to potentially increase any profit. For example, if a trader wants to use a leverage of 1:100, it means that every dollar that is exposed to risk actually manages $100 in the market. In this way, all those who wish to trade or invest, use the leverage to maximize their profits in any particular negotiation or investment.
In the trades that are carried out within Forex, the leverage in the offer is, in general, the highest that is available in the market. Likewise, the different leverage options are established by the broker and therefore can vary: 1:1, 1:5, 1:10 or even higher figures. Brokers are in charge of allowing traders to adjust (higher or lower) the level of leverage, but they will also set the limits. For example: the leverage we offer at Libertex has a maximum of 1:10. However, customers are free to select a lower level of leverage.
Example of Leverage
Imagine that you have $5,000 in your account to carry out operations, so trading with a leverage of 10:1 would give you a power of $50,000. The leverages are determined in proportions, therefore, the leverage that you will have achieved will be 10:1. If the position you opened reaches $5100, you would earn 100% of the profit, which would be $100. The leverage in this case allows you to earn 10 times more the capital with which you started.
Now, consider that your leverage is 1:1 and you must reach $500,000. A leverage of 1:1 means that your investment of $500,000 could also increase to $501,000, but there is a difference... You would be risking your investment of $500,000 to obtain a profit of $1,000, so your earnings would only represent 0.2%.
The reason that leverage and Forex trading is so popular is that you do not require $500,000 to invest. A leverage of 1:1 is no longer attractive, when Forex offers a leverage of 10:1.
Now, what is margin?
The use of the margin in Forex trading is quite common for many users, but at the same time there is a great confusion about the term. The margin is nothing else than a deposit made by a merchant and that fulfills the role of a guarantee that keeps a position open. Often, the margin is confused with a fee for a merchant, but it is not, the margin does not represent the cost of a transaction.
When a trader decides to trade with margin, he should remember that the amount of margin he will need to maintain an open position will depend on the size of the position or the number of open positions. The greater the number of positions, the greater the margin required.
In other words, the margin is an amount of money that is deposited in good faith, to open a position with your broker and insure the same in case of losses.
The broker uses the margin deposited to maintain your position. This basically deposits it together with the margins of all the users and then uses all that amount to open the positions in the currency markets.
The margin is usually expressed as a percentage of the total amount of the position. For example, most Forex brokers require a margin of 0.25%, 1%, 2% or even 5%.
As we mentioned earlier, there is a lot of confusion regarding the concept of margin. However, there are different terms that include this word and that you should know to understand what each of them is about, here we explain them:
The margin requirement is the most used and it is about the amount of money that your broker requests to open the position, it is reflected through percentages. On the other hand, the margin of your account is not more than the total amount you have in it.
The used margin is the amount of money that your broker has used to keep your positions open. Although this money is still yours, you can not use it until your positions are closed and your broker returns it or until a margin call occurs. The latter is an amount of money requested by the broker to be deposited in your account and keep your positions open, in the event that the required margin of your account falls below the limit for the losses you have suffered.
Finally, there's usable margin, which refers to the money that is in your account and that you can use to open new positions in the market.
What are the risks of leverage and margin?
Leverage, in spite of being beneficial for many users, is also a double-edged sword, since you will have both winning and losing chances. In the case of leverage, the user has more money to use and, therefore, make more transactions, so if the operation is successful you can increase the amount you want to exchange and increase your profits... but the opposite can also happen.
If the currencies involved in the leverage move in the opposite direction to the user's investment, the loss of money could be considerable. This is where the risk of leverage lies and the reason why traders are advised not to risk more than they accept to lose.
How can I minimize these risks?
Previously we commented that the margin is the amount of money that is deposited to open a position and that it immediately enters into risk depending on the variations that occur in the currency market. However, there are some methods that will help you reduce those risks.
The first method is stop loss. On this occasion the trader selects a rate that will indicate the loss limit of a specific operation. If the operation reaches that rate, it will stop automatically. In this way, you control your investments and do not lose more than you are willing to pay
The second method is take profit, which closely resembles stop loss . The difference is that, in this, a profit rate is set that can be modified (while keeping the position open) and allows the trader to control the negotiation without the need to be regularly observing the possible fluctuations.
While it is true that each business includes risks, there are ways to minimize them. The most advisable thing is to understand all the aspects and terms mentioned above and that involve the world of Forex. With them you will learn the best methods and use rationally the leverage and the margin, avoiding losses and, therefore, potentially increasing your profits.
If you decide to try operations with leverage, in Libertex we will be happy to offer you the best conditions. Our CFD service covers a wide range of asset classes. For beginners, we are pleased to offer you a demo account, through which you can practice trading using leverage, without any risk of losing money. Do not wait any longer!