What is leverage and how this figure allows you to trade a much more considerable amount of money when Trading Forex? Interesting question, isn’t it? Today, we are going to talk about this unique tool that works in the whole financial system.
Leverage works like magic. Imagine that you only have $200, but you are allowed to place a $10,000 position. How is that possible? You could think it is like magic, but the truth is that you are working with a 1:50 leverage.
That being said, leverage increase your potential gains, but also the risk you are taking, so losses can be more significant than usual. Before trading forex, you need to know what leverage is, how is it calculated, and overall, how leverage works in the Forex market.
What is Leverage
Leverage is commonly known as a double-edged sword. You can multiply your profits but also your losses. Why? Because leverage involves the ability to control a large amount of money while using a small amount of your own money as your forex broker will allow you to trade as much as you can lose.
Let’s say that you are trading with your own money in the stock markets. To purchase a share of Amazon, which value is $2,000, you are going to need the full $2,000. However, in the Forex field, if you use a 100:1 leverage, the same $2,000 would give you the ability to control $200,000.
Long story short, when trading with leverage, you will be able to place positions that are greater than the money you have in your account.
In plain English, a good sample of leverage is when you want to buy a car, you don’t have the capital available, but you have a wage or salary, and you can use it to pay the installments regularly. So, you go to the bank and borrow money to pay for the car at the car dealer. In this sample, you are leveraging your income.
Most common leverage amounts:
1:1 – One to one trading. It is not leverage, and you are going to trade the money you have. If you want to buy 50 euros, so you will need to have the equivalent amount in the other currency. It is placed here for reference.
10:1 – Ten to one leverage means that for every $1 you have in your account, you can place a position worth up to $10. If you have 100 dollars, then you can trade with a 1,000 dollars trade.
50:1 – The fifty-one leverage is that you can trade $50 per each dollar you have in your account balance.
100:1 – The typical leverage in most platform says that every dollar represents $100. So, with a $100 account, you can place a 10,000 position.
200:1 – The very risky two-hundred to one leverage allows you to trade up to 200 dollars per every $1 you have. It is typical for mini lot accounts.
400:1 – Ultra leveraged accounts with 400:1 are offered by specific platforms in countries with a not-that-strict regulation. It says that every dollar represents 400 dollars. So, if you have a $1,000 account, it would allow you to open a $400,000 position.
To calculate the money you can trade with specific leverage, just multiply the amount in your account balance for the leverage you are going to trade. So, if you have 10,000 and your leverage is 100:1, you will be able to place a 1,000,000 position, which is a lot.
What is the margin?
As leverage is the degree to which an investor is trading with borrowed money, you should get the money from somebody. Well, forex brokers allow you to open positions with smaller amounts of money as they act with a “good faith deposit.”
DayForex Dirk Du Toit says that “forex broker-dealers automatically liquidate their customer positions almost as soon as they trigger a margin call. For this reason, Forex costumers are rarely in danger of generating a negative balance in their account.”
Certain conditions allow the broker to lend your money, or to act on your behalf as deposit-backed leverage. That means that they will let you trade if you have enough money to afford losses.
Margin is expressed as a percentage amount of the position. It could be 2%, 1% or even 0.25%. It is up to the broker and regulatory conditions they should meet.
Depending on the margin you are allowed, it will determine the leverage you can trade. For example, usually, a 2% margin means you have a leverage of 50:1. Also, if you have a 1% margin, you have a 100:1 leverage.
With a 200:1 as maximum leverage, the margin requirement is 0.5%%.
With a 400:1 as maximum leverage, the margin requirement is 0.25%%.
Requirement, used and usable margin
Long story short, margin requirement is the amount of money the broker requires you to place a position. It is a percentage of your account that you should have in your balance as long the position is opened. You can not use it.
In this framework, the used margin is the amount of money you have locked up in your account because you are using it in a position. Usable margin is the money in your account that you can use to open new positions.
The account balance is the total amount you have in your account. It is the sum of your used and usable margin. In other words, it is the money you have settled in your balance, and it is not used in an open position. Some brokers allow you to have a look of all the money you have, including open positions at current valuation.
The margin call
Margin call. You don’t want to experience a margin call, and it is practically impossible in the forex market, as Dirk Du Toit explained before.
Forex dealer will close your positions as soon as you can not afford more losses. If you have $500 in your account, your trade can not go $501 in negative. It can go 409 dollars down, and then recovery, but if the position hits the $500 losses, it will be closed.
Should I use leverage in Forex?
Investing is about making money, but before making money, you should be sure that you need to be in the market. So it would be best if you survived every single day. Leverage is good, but it can be painful.
Most of the accounts that are wiped out are always high leveraged. Dirk Du Toit finally made a thought in his article, “Just a thought from the sideline. If trading forex is mostly with borrowed funds why don’t the brokers ask interest? Think about that…”
Leverage is the blood of Forex, but you should use it wisely.