Forex leverage and margin explained

Leverage and margin are two concepts that are interrelated and something which traders come across ever so often.

Leverage in forex, allows traders to borrow a higher investment amount using a fraction of the amount required. In other words, leverage is used in forex to magnify your investment capital, which in turn can put the trader at a better edge to get higher profits with the trades.

Obviously, along with the potential for higher profits, leverage can also set you back in the same amount. This is especially true if the trade you placed using leverage resulted in a loss.

And this can happen regardless of whether you are trading in an ECN trading environment or otherwise. In a non-dealing desk environment, this occurs because  currency pricing is volatile during peak hours of liquidity. Examples of this can occur during news events and economic releases.

Leverage and margin are important from a risk management perspective which requires traders to make use of advanced techniques for better managing their risks.

Experienced traders use leverage as an option to gain access to markets that were previously impossible to reach by making use of large amounts of capital without having the need to invest the said amounts into the trading accounts.

What Is Leverage in Forex trading?

Let’s first begin by explaining the concept of leverage in forex.

The concept of leverage is that you borrow some money in order to invest. From a forex perspective, leverage is the amount you borrow from your forex broker in order to trade the instruments.

Most forex brokers offer leverage from 1:1 and can go as high as 1:1000.

Well, the broker is not misleading you by offering such leverage. In fact when you use high leverage for an initial margin requirement you immediately build up a huge pot of money.

It is perhaps for this reason alone, traders tend to make use of high leverage rather than sticking to a more realistic leverage.

How does Leverage and Margin Work

When you open a live trading account, the first steps is to look at how the currency prices are moving with the broker in question. With ECN brokers that offer 5 decimal pricing, the 5th decimal is one that constantly keeps fluctuating.

While it might not seem much to trade with say $100 only to make a few pips of gain, using leverage traders can exponentially increase their profits.

Forex margin is a part or a certain percentage of your forex trading account capital that you are risking in a trade. In other words, margin is nothing but the percentage of your capital that you trade. So if for example your forex account is funded with $10,000 and you place a trade with $100, the margin you are using is 10%.

Forex margin trading can help traders to improve their profits while trading.

So while trading on leverage and margin, any losses incurred needs to be quickly covered, which is done via the remaining capital in your forex trading account.

The risks of high leverage

The best way to make use of forex leverage and margin is to understand two basic terms, namely:

Take Profit Rate, which is nothing but the rate or price at which you want to close your trade. In other words, if you expect to make 20 pips gain in your trade, then by using take profit, your trade is automatically closed when the price moves 20 pips. Take profit, in a way can be seen as limiting your trade’s potential to make you money, but it is a good practice as greed is often one of the primary causes for traders who end up losing.

Stop Loss Rate, is when you set the maximum loss that your willing to risk in a trade. When your trade reaches the stop loss position, it is automatically closed, thus preventing you from incurring any additional losses.

Leverage and margin are great ways for traders to make big profits quickly, when executed correctly by setting up proper stop loss and take profit levels. Most brokers offer leverage starting from 1:1 up to 1:500. However, choose your leverage carefully as it can be one of the determining factors to your success in forex trading.

Is Leverage really that important in Forex?

In forex trading, price movements are measured in Pips, the small change in the currency’s price. The Pip value is usually the fourth or fifth decimal point in the currency’s price.

If you look at a currency’s exchange rate at face value, there is little to none movement because of the minute fraction of the cents movement. And if you were to trade in actual pips, the profits you make are almost negligible. It is for this reason that leverage is used in forex so as to increase the amount you trade which is then translated to a profit that can be considered to be decent.

To put it in perspective, if you were to trade 1 lot, or $100,000 then fractional pip movements now amount to something more substantial than just profiting in cents.

Forex brokers usually leave the choice up to the trader as to what leverage they can choose.

Higher Leverage = Higher Risks

Forex leverage can be your friend or your worst enemy. But it depends on which side of the trade your are. Leverage in forex has the potential to magnify your profits and your losses as well.

Most forex brokers require on average a minimum of 1% deposit margin. So depending on the amount of leverage you are using, if the trade goes against you, your losses are also magnified in the same proportion.

Many forex traders using high leverage without a good risk management strategy end up losing all their balance in just a single trade.

Setting up stop losses using high leverage alongside a trading strategy helps you gain big profits. At the same time, it can minimize your risks.

But such kind of high leverage trading requires technical skills. Most beginners focus on the profits one can make from using high leverage. But experienced traders stay away from using high leverage. This is because the potential losses clearly indicate the level of risk they are getting into.

While forex brokers offer high leverage, the onus is on the trader. At the end of the day, you choose a leverage that you think is right for you.

Choosing your leverage wisely

Using the allowed leverage gives you the flexibility to set up a wider stop loss. On the contrary, higher leverage on your trade can quickly eat up into your margin. This results in you losing more that what you intended to.

In other words, higher leverage reduces the flexibility on the stop losses. As a result leverage gives you a very small profit window.

Leverage is flexible and is often customizable to your trading requirements.

A good example of forex leverage is given by how one uses their credit card.

You know that you have access to additional borrowing, but it comes at a cost. Just because leverage is available doesn’t mean you must use it. Always consider the worst case scenario before you take the plunge.