Both leverage and margin are key terms you should familiarise yourself with and make sure you understand well before engaging in any trading activities.
The truth is that if you use leverage wisely, you stand a chance of significantly increasing your profits.
However, as any trader will tell you, ‘leverage is a double-edged sword.’ This basically means that it is more than likely you will blow up your account within seconds if you don’t understand or ignore the risks involved when using leverage.
So what is leverage?
Leverage is what enables investors to control positions that exceed the value of their initial investment.
A simple example: The use of mortgages that allow home-buyers to purchase properties that are worth more than the amount initially invested is one of the most commonly employed types of leverage.
In FX trading, however, using leverage means using very little of your own funds and borrowing the rest from your broker so as to trade a larger volume.
Leverage is expressed as a ratio. Let’s see how it affects the size of your trade:
|INITIAL INVESTMENT||LEVERAGE||TRADE SIZE|
|$1000||1:1 (no leverage)||$1,000|
Before we explain how using leverage can both increase your profits and maximise your losses, we have to look at what margin is.
Margin can be thought of as the deposit required when using leverage. It is the funds you should have in your account in order to maintain your positions.
So, in other words, margin is the percentage of your account balance that is secured every time you open a leveraged position. The exact amount depends on the size of the position and the leverage being used.
The margin required to open a position is calculated as follows:
Trade size in units / Leverage = Margin in base currency
Trade size in units / Leverage X Exchange Rate = Margin in quote currency
Let’s see how the amount required as margin is dependent on the leverage you use when trading 100,000 units of a currency pair:
|MAXIMUM LEVERAGE||REQUIRED MARGIN|
From the above, you can easily see that:
- Higher leverage → Less funds required as margin
- Lower leverage → More funds required as margin
So, if you want to buy one standard lot (100,000) of EUR/USD without using leverage (1:1), you need to have €100,000.00 in your account. However, with a leverage of 100:1, you would only need €1,000.00 as required margin. With a leverage of 200:1, you would need €500.00, while with a leverage of 400:1 you would only need €250.00 as required margin.
So, to sum up, required margin is the amount of money required to open a leveraged position.
Free margin is the amount you have in your trading account that is currently not being used to guarantee any positions. In other words, it is the amount you can still use to open new positions.
[Free margin = Equity – Used Margin]
Equity is your trading account balance plus or minus the profits or losses from any open positions that you have.
Margin level is calculated as a percentage and is the ratio of your equity to used margin. When your margin level drops to 100%, it means that all of your trading account balance is being employed as margin and no further positions may be opened.
Margin call is a dreaded thing. If you get a margin call, it means that your equity has fallen below your used margin and that the amount of money in your account can no longer cover your possible loss.
Pros and cons of trading with leverage and margin
Leverage is not a bad thing. It is, however, massively risky to trade with leverage if you do not have a clear sense of how it can work against you.
The example below will show you both the pros and the cons of trading with leverage and margin:
You deposit in your account €1,000. Without the use of leverage (or with leverage 1:1), you would only be able to control a €1,000 position. However, with a leverage of 100:1, you can control a €100,000 position, and your initial investment of €1,000 will be set aside as margin.
Now, let’s look at two possible scenarios:
Scenario A: With your initial investment of €1,000, you control a position of €100,000. Its value soon rises to €101,000 (+100 pips). This is good news. It means that you have made a profit of €1,000 by depositing only €1,000. In other words, your return is 100%!
Scenario B: With your initial investment of €1,000, you again decide to control a position of €100,000. However, instead of rising, this time its value falls by €1,000 (-100 pips). Now this is bad news. It means your investment/margin of €1,000 has disappeared, quite literally, in the blink of an eye.