Traders can trade with big amounts of money even with as little as a thousand dollar deposit. Although it is not wise to trade with that little amount, it is still possible because of “leverage.” So how does leverage work in the foreign exchange market?
Forex traders make use of leverage to significantly increase the profits that their investment can provide. Foreign exchange investors use leverage to get returns from the movements and fluctuations in the exchange rates of currency pairs. Leverage is used even in other markets like the stock market, futures market, etc. It is however in the forex market that the highest leverage can be obtained. Simply put, leverage is a loan provided by the broker to the trader that is handling his forex account.
For investors to trade in the foreign exchange market, he initially needs to open a margin account or the initial margin through his broker. Depending on the broker and the size of the position that the trader wants to take, the leverage to be extended may be 200:1, 100:1 or 50:1. The broker will tell you how much they would require you to deposit for the position you will trade. For instance, you may trade a single lot of $100,000 for your $1,000 deposit in the margin account. Having $10,000 then, would allow you a leverage of up to $1,000,000.
Depending on the broker, the minimum security or margin may vary. Above example provides for a 1% margin. A trade like the aforementioned provides a leverage of 100:1. Leverages and margins are expressed in ratios. The relationships of the two terms are as follows:
Margin percentage = 100/leverage and Leverage = 100/margin percentage
Hence the leverage ratios mentioned above, which are, 50:1, 100:1 and 200:1.
Although to some, this leverage may look risky, it actually is not if you will consider that the movement of currencies is not too significant, usually less than 1% in a day's trading. If for example, your account goes down below the required margin, also called the usable margin, the broker will have to close either all positions or some of it. This way, the account will not reach a negative balance as leverages as big as these are not extended to investors trading equities since equity fluctuates greater than currencies.
To illustrate once more, you, as trader, will open an account with $3,000. You get 1 lot of CHF/USD with the required margin of $1,000. At the start, your usable margin is $2,000. But since you opened a position that required you a margin of $1,000, your usable margin has lowered to the remaining $1,000. Given this example, you can deduce that usable margin is the available amount in your forex account that you can still use in opening positions or sustaining losses. It is your security. Should your position worsen and your losses exceed the $1,000 usable margin, your broker may initiate what is called a margin call. If this happens, the broker advises the investor to either close his existing position or deposit more money in his account. This way, you will not lose more than the amount of your deposit.
Each broker may have their own policies when it comes to the matter of margin accounts. Policies of each broker may vary, but what is important is that the trader is very much aware of these policies and the risks attached to it to prevent problems while trading. Note that during weekends, a higher margin is required. Your 1% margin on weekdays may become 2% on weekends.
Leave a Reply