MARGIN AND LEVERAGE
What is Margin?
Margin is a term used in the financial world to describe borrowing money from an investment bank or broker with the intention of using it for high-risk investments.
In forex trading, margin is the amount of money your broker requires of you in order to open and maintain the trading position in your account.
E.g., to buy $100,000 (1 standard lot) of USD/CHF, you do not need to have the actual amount. You will be required to have a portion of this amount, say $1000. This amount required is dependent on the forex broker that you are using.
Margin is a percentage of your total capital and is different depending on which currency pair you trade.
How does margin work in practice?
First the trader has to deposit money into their trading account before opening a position. For example, your broker requires a margin percentage of 2%. For you to be able to open a trade of $100,000 units, you would require an account of $2000 (2$ x 100,000). The remaining $98,000 would be supplied by the broker.
This amount of margin is held to ensure the trade position remains open, provided it does not exceed $2000, at which instance you would receive a margin call, and you would have to add more funds to your account or close all trades. The broker may liquidate your account if you fail to deposit more funds or if you do not close trades to protect the account.
Normally the broker would notify the customer that their account is at risk.
What is Leverage?
Leverage is basically using funds borrowed by the broker to increase your trading position. Using leverage, can inflate your profits but also increase your losses.
In forex trading, brokers offer high leverage. To calculate the margin-based leverage, use the following formula:
Margin-based leverage = Total vale of trade / Margin required
E.g., if your broker requires a margin of 1% , and you trade a standard lot of USD/CHF. One standard lot would be $100,000, the margin needed is 1% of $100,000 which is $1000. Applying the above formula, the leverage required for this position is 100:1 (100,000 / 1,000).
Risk of using leverage
The risks of using leverage are more pronounced when the market is volatile, so you need to be extra careful when using this method. Although the leverage in Forex works just like leverage in other areas (mortgages, cars, etc.), it is particularly important to note that unlike other forms of leveraged investment, you do not own your position. This means that if the trade moves against you and your broker decides to close out the position, you do not get to keep any of the profits from that position.
Forex traders should access money leverage through their brokers. It allows them to multiply their positions and magnify their profits while at the same time significantly increasing their risks as well.