Understanding Margin and Leverage

In forex trading jargon margins and leverage imply margin trading or leveraged trading. In reality you can start forex currency trading with a very small amount of capital outlay called as initial margin. Leverage is expressed by ratio and margin is stated in terms of percentage. Forex trading brokers offer leverage ratio starting from 50:1 and it can be as high as 200:1. The same thing when expressed as margin percentage, it can be stated that the margin required is 1% if the leverage ratio is 100:1.

• For example if your forex trading broker asks you to pay 1% margin, then you have to pay 1000$ for buying or selling 1 standard lot size of 100,000 units of any forex pair. Alternatively to put in plain words, you are getting a trading exposure multiple of 100 times on your initial margin.
• All the future markets of stocks, indices and commodities work on leverage or margin. Margin percentage depends upon the market segment, exchange and the broker.
• Forex currency trading markets offer the highest leverage or impose lowest margin requirements. This is the most important advantage of global forex trading business.
• Most of you must be aware about the magic of compounding. Same holds true for margin trading in forex. Let us see an example on what wonders can margin trading or leverage create.

Analysis and Conviction

Your analysis and conviction dictates you that EURO will appreciate to a level of 1.5600. In anticipation you buy 1000 EURO/USD at 1.5550. As a matter of fact you have bought 1000 EURO by paying 1555 USD. Your trade turns in your favor and the exchange rate goes up to 1.5600. Immediately you sell 1000 EURO/USD at 1.5600. You have sold your 1000 EURO in exchange for 1560 USD. Let us work out the profit under two different scenarios.

• Without leverage: Profit = 1000 x (1.5600 – 1.5550) = 5 USD. Your return on investment (ROI) is 0.5%.
• With leverage: Let us presume that your forex trading broker has given you a leverage of 100:1 Now with the same investment of 1000$, you are in a position to buy 100,000 EURO/USD. Profit = 100,000 x (1.5600 – 1.5550) = 500 USD. Your ROI is 50%.

Don’t you think that magic of leverage creates wonders? Well, it does, but let me caution you that there are dark sides as well. Suppose if the trade went against you and EURO/USD fell to 1.5500. You will land up with a loss of 5$ without leverage but the loss would be 500$ with leverage. Do you realize the actual implications? You have ended up with a loss of 50% of your capital in just one trade.

Summing Up

• Risk management is an extremely important function in forex trading.
• Risk management and surveillance systems followed by forex trading brokers and forex trading company are different. In case your forex trading position is making huge losses, you may be called upon to jack up your margins. It may happen that in the event of acute volatile market conditions your loss making position would be squared off automatically by the forex trading system.