Last update 2020.08.08
The concept of margin and leverage is ubiquitous in forex trading. What exactly is leverage and margin? The short answer is these two terms are each different sides of the same coin, below we will go into further detail, starting with margin.
Margin is like a deposit requirement that becomes locked up when make a purchase, such as when buying real estate, but in this case, it is to open a forex trade.
The down payment in a real estate purchase might only be 10% of the value of the property, thus the margin requirement can be thought of as a percentage down payment towards the overall transaction value.
Margin in forex markets
In financial markets this concept of margin is similar, except that if the value of the trade changes rapidly, you might need to deposit additional margin to avoid having your position liquidated, known as a margin call.
Leverage simply measures how far your margin can go in terms of controlling transaction sizes.
A trader looking to purchase 10,000 units of the GBP/JPY currency pair at an exchange rate of 143.21 Japanese Yen for each unit of British Pounds, and at a margin requirement of 10%, will have to have to use the equivalent of 143,210 JPY as margin, based on the trade value of 1,432,100 JPY (equal to 10,000 British pounds). In other words, the trader needs at least 1000 GBP to purchase 10,000 GBP, relative to the other currency. This is a form of 10% margin, equal to 10:1 leverage.
Below is a help list of various margin levels and their associated degree of leverage:
- 100% margin = zero leverage
- 50% margin = 2:1 leverage
- 25% margin = 4:1 leverage
- 20% margin = 5:1 leverage
- 10% margin = 10:1 leverage
- 5% margin = 20:1 leverage
It’s crucial to remember that the lower the margin requirement and higher the associated degree of leverage, the higher the risk is of losing all your money.
Leverage is comparable to credit in forex
Leverage in forex trading is like a credit mechanism that allows forex traders to take positions, whether buying or selling, which are of significantly higher value than the funds they have available in their account. Leverage also provides a is a solution to hedge an amount of your portfolio by using only a fraction of the available cash balance. Most of the Brokers display that information on their trading platform, you can see some examples here.
The amount of available leverage varies widely among forex brokers, and you can have a very different result if your margin is of 50:1 compared to 400:1 in the forex market. A margin requirement of 0.25% (which is 400:1 leverage) provides eight times more leverage when it comes to potential earnings or losses, compared to 2% margin (which is 50:1 leverage).
In practice, leverage reflects the fact that a broker lends investment capital to traders who are in effect borrowing the leverage amounts, using just their margin deposit as collateral. Therefore, this mechanism allows you to reap larger profits, if you achieve good performance, or larger losses if you don’t manage your forex trading properly.
Overall, using leverage is not for everyone as the potential losses it can generate can be significant. Extreme caution is required when using leverage, along with a good understand of the margin requirement level, as that will determine the degree of leverage.
Leverage as notion of risk
We can think about leverage as a notion of risk, because smaller margin requirements mean bigger degrees of leverage, which causes more sensitivity to risk when the underlying price changes. Some positions can even lead to losses larger than the total amount available in the trader’s account, causing a negative balance.
One useful tip is choosing a forex broker that has a mechanism automatically close positions to prevent bigger losses when your available cash reaches zero. It can minimize the risk of a negative balance. For reasons such as these related to the risk of using leverage, it can be prudent to use little or no leverage, depending on your trading strategy and goals. You can learn more about leverage and margin in other texts here in the Wiseinvest Educational content section.
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- Smaller margin percentage requirements mean increased degree of leverage and more chances to make greater returns, but it will also increase risk of greater losses.
- By subscribing to Wise-Signals, traders will not need to analyze which leverage to use, because our signals have a risk management calculator.
There is no such thing as certainty in forex trading, but you can do better with the right education and information. Furthermore, WiseInvest leverages Artificial Intelligence to add value to our Wise Signals subscription service.
Margin and leverage in forex trading: Did you like what you read? Learn more about the types of investment markets here.
Disclaimer: Forex and Contracts for Difference (CFDs) are complex instruments and come with a high risk of losing money due to leverage. Forex trading is not suitable for everyone. You should consider whether you understand how forex and CFDs work and whether you can afford to take the high risk of losing your money.
The forex brokerages displayed shall disclaim the overall performance of traders in their platforms. Oanda warns that 76.8% of retail forex traders lose money trading CFDs. XTB warns that 80% of retail forex traders lose money trading CFDs. The forex broker Fxcm warns that 69.66% of retail forex traders lose money trading CFDs.
The performances aforementioned are not related to Wiseinvest AI forex trading and AI forex signals system. You can check the performance of our AI forex system on our dashboard.