Understanding Leverage and Margin in Forex Trading and Avoiding Disaster
Making reasonable profits in forex trading means multiplying the size of the trades that you make – at least, to a certain extent. Understanding leverage and margin is an important part of this, so that you can maximize the advantages, and minimize the disadvantages. To do this, let’s start with two simple definitions.
What is margin in forex?
Margin is the amount of capital that you personally make available for your currency transaction. This is simply your initial deposit or the funds you have in your trading account.
What is leverage in forex?
Leverage is the factor by which you multiply the size of a particular trade by borrowing somebody else’s money (your broker’s money). For instance, you might open an account with $10,000 (your total margin), and then use leverage of 50 to 1 (50:1) to make a trade on $50,000 of currency by using just $1,000 of your own money and borrowing the rest.
The reason for using leverage is to increase total profit levels. Remember, first of all, that movement in currency pairs, such as EUR/USD, is defined in “pips.” In this example, each pip corresponds to a change in the exchange rate of 0.0001; for other cases this may vary, but we’ll stick to this definition here. So if the market for EUR/USD were to move from 1.3312 to 1.3412, then it would move by 100 pips, the equivalent of $0.01 per dollar. At a single dollar level, this is insignificant. To make more profit, assuming you identify a trend that is positive for you, you would buy a block of currency. If you bought $1,000 worth of currency, then a 100 pip move would now represent $10 of profit. If you apply leverage of 50:1, a 100 pip move becomes a $500 profit.
However, thinking about this for a second or two will show you that in the same way that you can multiply profits, you can also multiply losses if the market moves against you. Brokers advertising leverage of 200:1 or even 400:1 are simply accelerating both possibilities, sometimes with disastrous results for a trader, but (we’ll see why below) not for the broker.
Forex leverage example
Too much leverage can literally wipe out a trading account. Suppose we have funds in an account of $10,000 (that’s our margin), and we decide to use $2,500 of that and leverage of 400:1 (!) to buy $1,000,000 of a currency, or if you prefer, 10 “standard lots.” Unfortunately, the trend we were trading on reverses and the market moves 100 pips against us. On a single dollar basis, that’s just one cent; however, in the case of the trade we are making, that becomes $10,000. In other words, all the funds in our account are now needed just to cover the potential loss.
At this point, or even before, the broker will make a “margin call.” This means the broker will close the trade, whether we like it or not, using all of our $10,000 to pay for the loss, recover the money it lent for the leverage (brokers do not lose out), and leave us with… zero dollars in our account.
Could this really happen? Unfortunately, yes it can, and even quicker than you think. Even if a trade is ultimately positive, a sudden spike or a dip in the exchange rate just after you open your trade could be all it takes for a “margin call” to put an end to your trading. So how can you use leverage so that you can aim for reasonable profits, but avoid devastating losses?
Here are some common sense alternatives to show how the trade in the example above could have been done differently:
- Moderate the amount of leverage you use. In some cases, you won’t have a choice – for example, in the US, leverage for retail forex trading is now limited to a maximum of 50:1.
- Use a smaller portion of your margin per trade. Around 5% might be appropriate, rather than the 25% above. This slows down the overall effect of leverage on your account, but you still need to manage your trades to maximize profits and minimize losses.
- Use stop-loss orders appropriately. Set stop-loss orders to allow some breathing space for your leveraged trades, but at a level that prevents any catastrophic damage to your account.
In summary, leverage used in a planned and moderated way can help increase trading profits. However, your underlying trading system should also be profitable (with or without leverage), and should avoid situations where runaway losses could potentially eat up all of your trading funds.
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