5. Leverage & Margin
When it comes to Forex trading one should take into consideration two extremely vital concepts – the leverage and the margin. This is so, as these concepts could easily cause worries, in case they are not used appropriately. The terms “leverage” and “margin” are related to one and the same idea, but however, in different cases.
Definition of “leverage” is having the ability to control a large amount of money using none or very little of your own money and borrowing the rest
Leverage is usually presented with the use of a ratio, for instance, 1:100 or 1:500. This relation states that for every $1 the investor deposits into his/her account, he/she is able to enter into trades worth $100 or $500. With the help of leverage, investors do not necessarily need to have thousands of US dollars in their possession in order to make trades in the market, where only large corporations or institutions could afford to participate several years ago.
What is margin?
Margin is the amount of money needed as a “good faith deposit” to open a position with your broker.
Margin is usually expressed as a percentage of the full amount of the position. For example, most forex brokers say they require 2%, 1%, .5% or .25% margin.
Based on the margin required by your broker, you can calculate the maximum leverage you can wield with your trading account.
Let us look again at the example we provide earlier. In Forex, a trader may enter into trades up to $100,000 with a mere $1,000 set aside. The leverage in this case is 1:100. The $1,000 that the trader deposited into his/her account is considered as the initial margin. This is what the trader had to give up in order to engage in the market.
Remember, your margin is the money you give to your broker as a deposit of good faith. The broker requires these margins from everyone and puts them together in order to make huge trades on the inter-bank network. The actual profit or loss you register in the market is dependent on the size of the trade you entered into, and not on the amount of margin required.