Defining the Basics: Leverage & Margin
This week I’ve been busy learning about leverage and margin, and hopefully I’ll be able to pass on some of what I’ve learned to you. Leverage and margin are two fundamental aspects of forex trading, and as such it is crucial to understand both concepts before getting started. So, first up: leverage.
Leverage is shown with a ratio, and basically signifies the amount of money your broker will lend you on top of your own money. This allows you to trade with much higher volumes, and therefore means a higher profit can be made. For example, if your broker’s leverage is 100:1, then you will be able to trade with 100 times the amount you deposited. Therefore with this leverage, a deposit of 1000 USD, will get you 100,000 USD to trade with.
Now, let’s say you invested the full 100,000 USD in an investment that later rose to 101,000 USD. With the 100:1 leverage this means your profit is 100%. Had your 100,000 USD been entirely self-funded - 1:1 leverage – then your profit would have been just 1%. So, leverage not only allows you to achieve a high profit, but also enables you to trade more easily and with a much smaller starting point – well, unless you happen to have a spare $100,000 lying around!
One major issue I had with understanding this concept was the idea that if you can make a profit with this leverage, there’s also the chance that you could lose money. However, whilst it is possible to lose your personally deposited funds, brokers will automatically cease your order if you reach the point of losing any leveraged money. It is also possible to place something called a stop loss on your order to prevent losing too much money – a topic that will be visited in more depth in a later post.
Now for margin. This is expressed in a percentage, and varies depending on the leverage offered by a broker. Continuing with my earlier example, if there was leverage of 100:1 and I placed 1000 USD, I would have 100,000 USD to trade with. The margin is simply the amount of money I needed to place in order to use leverage and open a position – in this case, my margin was 1000 USD.
However, there are a number of different ways that the term ‘margin’ is used, so here is a quick rundown of each of them for you, which you can refer back to if needed:
This is the margin I’ve just described. It’s the amount of money you need to use leverage and open a position. Depending on the leverage offered by a broker, the margin will change.
This is simply the total balance of your trading account.
The amount of money you have effectively ‘spent’ on trades. Whilst it is still your money, it is currently tied up in trades to keep your positions open.
This is the amount of money you have available to use to open new positions.
You will get this if the money in your account does not cover possible loss, and occurs when your equity drops below your used margin.