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Understanding Leverage and Margin in Forex Trading and Avoiding Disaster

By Alexander
In Forex Basics
Apr 13th, 2012
14 Comments
25338 Views

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.

what is leverage and margin in forex trading

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.

P.S.: Is Forex leverage explained for you now? If so, please share the article with your friends.

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14 Responses to “Understanding Leverage and Margin in Forex Trading and Avoiding Disaster”

  1. Cornix says:

    Good post. Many people indeed don’t realize that leverage is a double-edged sword and it can be not only profitable, but also dangerous. Myself I use about 20:1 leverage, but only for day trading with stop-losses of like 10 pips maximum. Use much smaller leverage for swing/position trading.

    • Alexander says:

      Thanks, Cornix. Let’s share the article and help more people to learn about leverage and margin.

    • Melford says:

      Hello Traders
      Thanks for the insights. I find it difficult to a set my stop loss parameters. For example my broker will require me to always set stop loss of 100 pis especially for majors is there any way I can reduce the pips to 10 or 20 am concerned. I am using meta trader 4 as my platform. Is it possible for me to customise the stop loss pips and how do I go about it? Your mutual aid is highly appreciated.

      • Alexander says:

        Hello Melford, many brokers have mandatory minimum SL level for each trade. However, I have never heard before about minimal SL 100 pips. Which broker do you use? What type of account?

  2. Yup – the warning is appropriate but what about the commission – generally of course hidden as spread? The lowest spreads are between the biggest currencies – EUR/USD generally but the brokers earn their commission by ~3 pips which is of course based on the amount leveraged rather than the amount spent. So they do pretty well out of it as long as the market moves regularly.

    Mind you I hadn’t realised leverage could go as high as 400:1 – I thought people would have learned their lessons over recent years!

  3. Jack says:

    Hey, When I started trading i’ve made a few mistakes with the leverage and I lost some money because of it. Now I don’t use more than 1/20. What I don’t understand is why traders need a leverage of 1/100 or even 1/200, isn’t that too risky? Are there any strategies that in order to apply them you have to use a 1/200 leverage?

    • Alexander says:

      Hello Jack, I don’t know any trading strategy that requires 200:1 leverage. However, leverage 100:1 can work fine if you have proper money and risk management.

  4. Paul Yeomans says:

    Hi, great post. I’m also a beginner to FX and recently opened an account with FXCM. The leverage on the account seems to be fixed at 200:1 with no way of amending it, does anyone have any experience of whether that is correct?
    I am able to reduce my exposure by simply reducing the amount of lots I buy/sell but the ratio of used margin to position size always appears to be 200:1 which concerns me from what I’ve read. Thanks, Paul.

    • Alexander says:

      Dear Paul, do not worry about leverage if you trade according to FIFO rules or used to trading one trade after another (do not open 3-4 trades simultaneously). For example, leverage 200:1 can be dangerous when you are trying to open too many trades. Each trade with leverage 200:1 requires 0.5% of your margin when you have 20:1 – 5% of margin. So with 200:1 you can open 10 times more trades than with 20:1 at the same time.

  5. Buck Inspire says:

    Great breakdown on leverage and how it could turn out disastrous. It’s amazing this is offered. It does make sense as brokers make money no matter what. Very dangerous in the wrong hands. Guess we never learn, just look at the real estate collapse!

  6. chartung says:

    Hello everybody and top of the morning/evening to ya. I’m in the beginning stages of capturing pips and need all the help I can get. I’m studying Fibonacci’s and have backtested a couple of indicators in 1/5/15 minute charts using MetaTrader4 and i’m trying to find a good place to learn more about Metatrader4 and how to put it on autopilot for scalping and swing trading. To give you an idea of where i’m at I just happened to walk by my computer this morning and noticed the Eur/Usd was about to hit my trigger and went ahead and placed an order on a 100:1 practice account to see what would happen. It retraced after 15 minutes or so and took me out of the trade with an 80 point trailing stop. Should have left it at 90 to see how far that puppy would go but oh well, live and learn. My trigger finger was itchy when I looked at the profits in dollars on the trade and it had climbed to $250.00, that’s when I closed the trailing stop to 80 points and it eventually retraced in a few more minutes taking me out. So I need some more info on how to set up the Metatrader4 on autotrading. Can anybody help me out???? Thank you very much.

  7. Dev says:

    Hello, can anyone please suggest me a good platform to learn forex trading? With a least possible amount? as I have recently graduated.
    Thanks a lot

    • Alexander says:

      MT4 is a good platform to learn forex. Just open a demo account with a reliable broker as Armada Markets and train trading there.

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