What is Margin? What is Leverage? Table of Contents
What is margin?
This is, in essence, your safety net in percentage – this term is interchangeable with the term “collateral”.
It is the calculated required amount to have in your deposit in order to open a position on credit, as well as keeping that position open.
Consider it as a part of your funds that is locked until the closing the open position, as you open a position using leverage with more capital than you have on your trading account.
Before the investor can place a trade, he or she must first deposit money into the margin account.
The amount that needs to be deposited depends on the margin percentage that is agreed upon between the investor and the broker.
Example of Margin
For accounts that will be trading in 100,000 currency units or more, the margin percentage is usually either 1% or 2%.
So, for an investor who wants to trade $100,000, a 1% margin would mean that $1,000 needs to be deposited into the account.
The remaining 99% is provided by your broker.
No interest is paid directly on this borrowed amount, but if the investor does not close his or her position before the delivery date, it will have to be rolled over, and interest may be charged depending on the investor’s position (long or short) and the short-term interest rates of the underlying currencies.
If the investor’s position worsens and his or her losses approach the margin call %, your broker may initiate a margin call.
When this occurs, brokers will usually instruct the investor to either deposit more money into the account or to close out the position to limit the risk to both parties.
What is leverage?
A leverage allows you to open positions with more funds than you have on your trading account.
This allows you to increase your return, but acts as a double-edged sword as it increases the risk accordingly.
The amount of leverage provided is either 50:1, 150:1, 200:1, 500:1 or higher and depends on the account size (equity amount) and the size of the position the investor is trading.
Standard trading is done on 100,000 units of currency (1 lot), so for a trade of this size, the leverage provided is usually 50:1 or 100:1. Leverage of 200:1 is usually used for positions of $50,000 or less.
Example of Leverage
To trade $100,000 of currency, with a margin of 1%, an investor will only have to deposit $1,000 into his or her margin account.
The leverage provided on a trade like this is 100:1. Leverage of this size is significantly larger than the 2:1 leverage commonly provided on equities and the 15:1 leverage provided by the futures market.
Although 100:1 leverage may seem extremely risky, the risk is significantly less when you consider that currency prices usually change by less than 1% during intraday trading.
If currencies fluctuated as much as equities, brokers would not be able to provide as much leverage.
Leverage increases also risks
Although the ability to earn significant profits by using leverage is substantial, leverage can also work against investors.
For example, if the currency underlying one of your trades moves in the opposite direction of what you believed would happen, leverage will greatly amplify the potential losses.
To avoid such a catastrophe, Forex traders usually implement a strict trading style that includes the use of stop and limit orders.
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Comment by Diletta
March 26, 2024
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