Understanding Leverage and Margin in Forex Trading

02/17/2010 12:01 am EST

Focus: FOREX

John Jagerson

Co-Founder and Contributor, LearningMarkets.com

Leverage

Leverage is probably the one characteristic of the forex market that intrigues individual investors the most. Leverage is the ability to convert a small amount of power into a larger amount through the use of a tool. Imagine you are asked to move a large boulder from the spot where it is currently resting. You could certainly try to push and move the boulder with your bare hands, but your job will be much easier if you can use a tool—like a large pole—that you can place under the boulder that will give you some leverage.

The same principle holds true when you are investing in the forex market. You can make money by investing just your own money, but you can make much more money if you can use the tool of financial leverage by borrowing money from your dealer.

You can lever, or increase, the investing power of your forex accounts by using some of your own money to enter a trade and then essentially borrowing the rest from your dealer.

For example, if you have 100:1 leverage in the forex market, you can control $100,000 with as little as $1,000 of your own money. That means you only have to pay for 1% of the position with your own money. You can borrow the remaining 99% of the purchase price from your dealer.

Some dealers outside the US even offer leverage levels up to 400:1—which means you can control $400,000 with as little as $1,000 of your own money. While this may look appealing, don’t be fooled by the promise of potential profits that higher levels of leverage offer. More likely than not, higher levels of leverage will destroy your account before they help it grow.

The leverage you enjoy in the forex market is determined by the margin you are required to post for each trade.

Read more about leverage at LearningMarkets.com.

Margin

The forex market is an exciting market because your dealer is willing to essentially lend you money so you can increase your profit-generating potential in all of your trades.

Before your dealer lets you borrow money, however, you have to show that you have some money to cover any losses you may incur. Margin is the money you set aside with your dealer for safe keeping to prove that you are able to cover your losses.

For example, if you want to buy the EUR/USD, you will be required to set aside 1% of the position size as margin. That means if the position size is $100,000, you will be required to set aside the equivalent of $1,000 to prove to your dealer that you can cover losses of at least $1,000 should your trade move against you.

Different currency pairs have different margin requirements. Major currency pairs have lower margin requirements because their high levels of liquidity make it easier to enter and exit your trades quickly—which gives your dealer added confidence it will be able to close out your positions without incurring unexpected losses. Exotic currency pairs may have higher margin requirements because their low levels of liquidity make it harder to enter and exit your trades quickly.

Many beginning forex traders get confused by thinking that the money they set aside as margin actually goes toward purchasing currencies. It does not. You borrow 100% of the purchase price from your dealer. Your margin only shows your dealer you have money to cover any losses that you may incur.

When you buy a currency pair, you do not have to come up with the cash on your own. Your broker loans you enough of one currency to buy enough of the other currency in the pair. For example, if you click on the “Buy” button to buy the EUR/USD pair at 100,000 units, your dealer will loan you enough US dollars (USD) to buy 100,000 euro (EUR). If the EUR/USD exchange rate is 1.4000 at the time, your dealer will loan you $140,000 to buy €100,000.

Ultimately, your entire account is really a deposit against margin. If you bought one contract of the EUR/USD, which required $1,000 of margin to cover the 100:1 leverage ratio, but you actually have $7,000 in your account, you could lose more than the $1,000 margin requirement.

This is where traders get a little confused. Margin is the minimum required deposit to hold an open position. In the example above, $1,000 is the minimum account balance to hold the position. However, because you had $7,000 in your account, you could accumulate losses up to $6,001. Once you drop below the $1,000 minimum balance to hold the position, it would be liquidated.

If you look at this from an account perspective, although you have a 100:1 required margin ratio, or leverage, you are really only using 14:1 leverage (100,000/$7,000 = 14). Looking at it from an account perspective, it becomes more clear that 100:1 leverage is really just hype. You would never really use that in your account. Traders who do will find themselves wiped out very quickly.

By John Jagerson of LearningMarkets.com

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