Leverage and margin are the terms each trader starts with. The concept is simple, so even a beginner trader will catch on fast. However, there are pitfalls that may affect traders’ positions if they don’t consider crucial points. We summed up the useful information that will make your margin trading effective and prevent you from making mistakes that may cost a fortune.
The term leverage is quite simple and usually doesn’t raise questions in traders’ minds. Simply stated, leverage is a loan that a broker provides to traders so that they can increase their position size. However, you should remember that the loan is not for a precise term. You don’t own borrowed money and cannot use it to purchase an asset.
Leverage is a loan that a broker provides to traders so that they can increase their position size. However, a trader doesn’t own these funds.
Here, we should mention the term lot size. The standard lot size is $100,000. This means that if you want to trade one lot, you need to have $100,000. But what percentage of people have such a vast amount of money? Even if you choose smaller lot sizes – a mini lot of $10,000 or a micro lot of $1,000, odds are you won’t be able to provide the entire amount.
A lot size affects the amount you could earn. A standard lot allows you to earn $10 per pip. If you trade a mini lot, you can make $1 per pip. A micro lot will let you earn $0.1 per pip. So, it’s clear why traders care so much about the lot size. However, not everyone has even $1,000. That’s why brokers provide investors with a so-called loan. For example, you have $100, but even a micro lot is $1,000. So, a broker offers you 1:10 leverage. As a result, you have $1,000 and can open a position. Each broker chooses a unique amount of leverage. The smallest one is 1:5. This means that your own money will be multiplied by 5. The largest one is 1:1000. So, your funds will be multiplied by 1,000.
In common terms, leverage is the borrowed funds a broker provides a trader with. It looks like a bank loan. Nevertheless, it works differently. First, you don't have to pay the money back because you don’t own them. Second, your risks rise significantly. Here, lots of questions appear. Why do brokers provide traders with money if they don’t get it back or don’t get an interest rate? Also, why do the risks grow?
Leverage is accompanied by higher risks.
We are ready to answer these questions. If we talk about a broker's profit, we should understand that every broker gets a commission for every trade you open. So, they benefit from your open positions.
However, leverage is a two-way street. As for risks, you should understand the following rule. Imagine you have $100,000, and you earn $1,000. Here, your leverage equals 1:1, so your profit is 1%. If you have a 1:100 leverage, your profit will amount to 100%. Sounds good, doesn't it? However, the situation is similar to losses you may suffer. If you have 1:1 leverage, and you lose $1,000, your loss will be -1%. However, trading with a leverage of 100, you will lose 100% of your funds. It’s not so attractive anymore. For this reason, some brokers limit the leverage they offer to their clients. For example, the maximum leverage of Libertex is 1:30 for retail clients and up to 1:600 for professional clients.
Leverage is used not only in the Forex market. Traders can use leverage for different assets. For example, derivative investors apply for leverage to open larger trades. Also, you can trade CFD of oil, gold, and stocks via a broker. Here, you can also use leverage. Below you will see a list of the securities that are mostly traded with leverage:
We would like to share simple rules that will help you determine the perfect leverage that won’t hurt your funds in the case of losses.
There is no perfect leverage ratio. Otherwise, a wide range of them would not exist. We will give you an example of significant leverage and a small one. Comparing the results, you will be able to determine your perfect ratio.
As you learn what leverage is, you should know about another term. It’s the margin. When we talked about the leverage, you could question: how can brokers provide such huge funds? It looks dangerous to provide every trader with lots of money. However, brokers know how to protect themselves - they use margin.
Margin is the minimum sum that should be in your account to open and maintain trades.
Margin is not a fee for a transaction; it’s just a broker’s insurance that you will be able to operate open positions. Margin is locked by a broker when you open a new position. A broker should have a guarantee that your balance won’t fall below 0.
Imagine you have $100, you need 1:1000 leverage to open a 1-lot position. Your $100 will be a margin, the minimum amount you need to open a trade, and maintain it. A margin size depends on the number of lots and leverage. The larger the leverage is, the smaller margin you will need to fulfill. If the leverage is expressed in a ratio, the margin is depicted in percentage to the full position size. The size varies from 0.25%.
To calculate the amount of the required margin, you need to determine a percentage (or so-called margin requirement) of the position size (or notional value).
The required margin is calculated regarding the base currency of the pair you trade. It’s worth noting that if the base currency is different from your account's currency, the margin amount will be converted to the account denomination.
Margin is always seen in MetaTrader. However, if you look at the picture below, you will see that there are different types of margin terms. Let’s clarify each of them.
Simply stated, a margin account allows a trader to use leverage. To calculate leverage, you need to divide one by margin requirement. For instance, if the required margin is 2%, the leverage will equal to 50.
Inversely, to count the margin requirement, you need to divide one by the leverage ratio. For example, if your leverage is 1:100, the margin requirement will equal 1% because 1/100 is 0.01 or 1%.
Let’s consider an example of margin trading. Imagine you trade two currency pairs. These are USD/CAD and USD/JPY. You have $1,000, but you used a 1:10 leverage, so, you have $10,000.
The first trade is a mini lot of USD/CAD. The margin is 2%. The required margin will equal $200. The second trade is a mini lot of USD/JPY. The margin is 3%. So, the required margin is $300. In the end, we have a used margin of $500.
A margin call is a level at which a broker sends a warning to a trader that their margin has reached a dangerous point (40% or lower). A broker warns a trader to either close a trade to limit losses or add funds to stay in the market. A broker can but doesn’t have to close the trader’s positions.
Here, we should mention one more term. It’s a stop out. It would follow a margin call if a trader didn’t listen to the first warning. Stop out is a 50% level or lower that signals the margin has reached a minimum allowed amount. Here, a broker will close the trader’s deals without any alarm to prevent the balance from reaching negative figures.
Both terms have their own advantages and disadvantages. Let’s consider them to avoid mistakes.
Big funds. The main advantage of leverage and margin is an opportunity to operate larger funds than you have. As a result, you can open larger positions.
Larger losses. The main disadvantage of margin trading is the larger losses you will suffer when taking leverage.
More considerable profits. A larger position size provides an opportunity to gain more massive profits as lot size and pip value are interconnected.
Illusion. Another limitation you may notice is the illusion of significant funds. You should always remember how much money you have.
Limitations of margin and leverage directly relate to risks you may meet with. So, larger losses and an illusion of significant funds are the risks that may affect your trades' effectiveness. To minimize them, you have several options.
Previously, we talked about the Forex margin. To make it clear, we need to clarify what securities margin is.
A securities margin is borrowed money, which is used to buy stocks, ETFs, or bonds.
The amount usually equals up to 50% of the asset price. Here, we can use the term “buying on margin.” For example, if you buy stocks, you take a loan from a broker. It’s considered a down payment and allows you to own the security you purchase. When we talk about the Forex margin, it’s not borrowed money. And you don’t purchase currencies to own them.
To conclude, margin and leverage are basic terms of Forex trading. They allow a trader to open positions no matter what amount of money they have. This option is attractive. However, traders should remember the risks they might face. To know how to use leverage and margin, you should practice. It’s wise to do it with the small leverages that Libertex provides. The perfect place to practice new techniques risk-free is our demo account.
We gathered the most famous questions that every beginner trader has.
Leverage and margin have an inverse relationship. To calculate a required margin, you need to divide one by the leverage ratio.
To calculate leverage, you need to divide one by the margin requirement. Inversely, to count the margin requirement, you need to divide one by the leverage ratio.
We would recommend using 1:5 leverage that won’t increase the risk of losses significantly.
It means that the amount you have will be multiplied by 500. For instance, if you have $1000, you will get $500,000. It will allow you to trade five standard lots.
Leverage is a loan or borrowed money that a trader gets from a broker to open larger positions. Still, a trader doesn’t own the funds.
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