The terms “leverage” and “margin” are probably among the first words one will read in an article about forex; these will surely be repeated a number of times in a conversation about speculative trading of financial instruments. The entire forex and CFD industry to some extent lies upon the use of margin and leverage. For this reason, we felt these two key terms need to be addressed in a separate article. We hope you enjoy it, and do not hesitate to get in touch with us, should any questions arise in the process of reading.
What is Leverage and How It Affects Your Trading and Results
In trading, leverage is the opportunity provided by a forex broker to open a speculative position worth a much larger amount of money than you have at your disposal. The rest of the funds are thus lent to you from the company whose services you are using. For this financing, a client owes the broker an interest for each day he decides to keep his position(s) open overnight.
Leverage is expressed in ratios like: 200:1, 100:1, 50:1, etc. For example, if your online trading company blocks €1,000 from your trading account to open a 100,000 EUR/USD position, it means you are using a 100:1 leverage. Put in different words, you control €100,000 with only €1,000. Let us say that the market moves in your favor and the €100,000 investment rises to €102,000. If the entire capital were yours, your return would be 2% only (2,000 profit / 100,000 initial investment). This would imply you are using 1:1 leverage. Since you are using 100:1, however, and your forex broker has blocked €1,000 only to open your position, your return is the hefty 200% (€2,000 profit / €1,000 initial investment).
Leverage will not always work in your favor though. Using the analogical example: if you hold a 100,000 EUR/USD position and the market moves against you by 1%, your initial € 1,000 would be wiped out. In this case your return will be -100% (1,000 loss / 1,000 initial investment).
Margin and Its Specifics
It is time to address the term “margin” now. Let us go back to the EUR/USD 100,000 example for this purpose. To control this position, given a leverage of 100:1, €1,000 will be blocked from your trading account. This €1,000 is the margin that you need to open your forex trade; the amount of funds are blocked, so that you can use leverage.
Margin is often also referred to as “used margin”, which implies that there is one more term that needs to be addressed: “free margin”. The latter denotes the amount that is not currently utilized for trading purposes and is equal to the difference between the account equity and the (used) margin. In case there is more than one open position, the total margin will be the sum of all the used margins for every single open position.
Margin is expressed in percent of the full amount of the position (0.5%, 1%, 5%, etc.) . It can vary significantly between companies and between the various asset classes. Generally speaking, the more liquid a financial instrument is, the lower the margin (hence, higher leverage) a trading company will require from its clients for it; and vice versa.
You should have understood by now that, although leverage is expressed as a ratio, while margin is displayed in percentage terms, they basically show one and the same thing: a 0.5% margin requirement means that you are using a leverage of 200:1, a 1% margin requirement means you are using a leverage of 100:1, and so on.
As part of the general terms and conditions of a forex broker, margins and leverage are subject to change at any moment, sometimes even without a prior notice. This is of significant importance for you, as it directly affects your account. Imagine that your trading company decides to increase your EUR/USD margin from 1% to 5%, i.e. decrease your leverage from 100:1 to 20:1. Once the change takes effect, you will be required to provide €5,000 for margin instead of €1,000 to keep your EUR/USD 100,000 position open. In case you do not have enough funds to cover the requirement, your position will be automatically liquidated.