Importance of Understanding Margin and Leverage

Posted on 07th November 2017
Importance of Understanding Margin and Leverage

Margin and Leverage are important terms in forex trading. It is highly essential for all investors to understand these concepts thoroughly before setting out to trade in the currency market. By being ill-informed about these terms traders tend to either overtrade or undercapitalize their accounts. Leverage and margin criteria, laws & requisites vary among various brokerages and countries under operation. It is mandatory for investors to check with their respective brokerage firms for the specific rules that are applicable for their trading accounts.

 

What is Leverage?

One of the highest advantages of the currency markets is the one offered by trading leverage. Without the use of leverage, it would have been next to impossible for currency traders to accumulate sufficient capital to participate in the market that was earlier the sole prerogative for banks and financial institutions. Leverage is an essential aspect of the forex market not only due to the magnitude of capital required to set up trades but also because of the volatile market conditions. The concept of leverage allows for the existence of brokerage firms. These brokerages or liquidity providers also have accounts with banks and act as market makers for all margin transactions. In Forex Trading Leverage implies buying on a margin.

Leverage is what allows traders to control bigger trade sizes with minimal funds. It is expressed in terms of a ratio and depends on the margin requirements of your broker. For instance, if your broker needs you to maintain a 4% margin you must have at least 4% of the total cash available in your account in order to trade. For instance, using a 100:1 leverage you can set up a trading position for up to 100 dollars for every dollar in the account. Also, you can enter into a $100,000 position with merely $1000 in your account and technically reap the rewards of a $100,000 position. However, alternately you can also lose money based on a $100,000 position as well. Thus, Leverage is termed as a double-edged sword that can magnify your losses as well as gains. Investors who incur a loss without adequate margin in their account are liable to get a margin call.

 

How do you define Margin?

Margin is essentially a good faith deposit that you give to your broker in lieu of which you can enter into a larger trade size. Thus, a trader does not have to provide the full value of the trade but instead trade with borrowed capital. The amount of margin per trade depends on the underlying instrument, the current exchange rate and the trade size. The margin requirement is a percentage of the value of the trade. The general margin criteria is somewhere between 1% and 5% of the value of the trade i.e. a leverage of up to 100:1 and 20:1. However, few brokerages also offer leverage of up to 200:1(0.5%) and more. The currency denomination for the leverage through which you execute your trades depends on your brokerage but it is usually US Dollars.

 

Required margin:

It is the sum of money that is deposited with your broker when you enter into a trade. Required margin varies from broker to broker and also for different currency pairs.

Account margin:

It is the amount of capital that you have in your account for trading.

Used margin:

It is the amount of money that has been put in for all your open positions.

Usable margin:

It is the available money that can be used to trade outside of your open positions.

Margin call:

A margin call occurs when the available margin in your trading account falls below the required margin. In such a situation your broker will end all your open positions with immediate effect and you need to put in more funds into your account.

Concluding remarks:

While trading on margin and applying leverage may increase your gains manifold and help your account to grow quickly it is always advisable to look before you leap. That is because if a trade is not in your favour then you risk losing more than you had invested by trading on margin. Trading on margin is extremely risky and is only apt for the more enterprising traders. Alternately, you can cut down your risks by demo trading and back-testing a trading strategy before committing any actual money in a live setting, using stop-losses and not exhausting your entire margin balance. As the saying goes, 'It is better to be safe than sorry'.

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