Understanding Leverage and Margin in Forex Trading : SchoolGist

The two main ways to trade forex are speculation and hedging. Traders and investors use the former to profit on the rise and fall of the price of currencies. Hedging is used to lock in the price of a currency when doing international business because a change to this price can affect the cost of goods and services and, thus, a business’s bottom line.

Forex trading involves opening positions in one or more currencies to gain from the relative change in the price of a currency or currency pair, which is speculation. When doing forex trading, you will see the terms leverage and margin used a lot.

This article will help you better understand what they are and how they are related.

Understanding Positions

One of the terms you need to know when trading forex is position. A position is simply an expression of commitment by an investor or other person. It can also be thought of as the exposure someone has in the market. It can refer to ongoing trades that generate a profit or loss, known as an open position, or trades that have been canceled, which is a closed position.

Margin in Forex Trading

When trading , your forex broker will require only a small amount of capital to keep a position open. This amount is known as the margin and is set by the broker.

The margin is a percentage of the total amount for the position you want to open. In many places around the world, the margin for keeping a trading position open starts at 3% but doesn’t typically go above 5%.

Let’s say you want to buy $100,000 in USD/JPY because the relative change between the two currencies will earn you a profit. Your broker will ask for something like $3,000 to keep your position open.

Going back to margin, you should think of it as a deposit or collateral that signals to the forex broker that you are committed to the trade. Once they have this, they can keep a position open for you.

It is also important to understand that margin is not a broker or transaction fee; it is a portion of the money you already have in your trading account.

Because of this, a trader can run out of margin if they do not have enough money in their account.

When this happens, they receive a margin call telling them they need to deposit more funds into their account or close open positions.

The margin requirement is the percentage margin required. The trade discussed above has a margin requirement of 3%. The required margin is the amount needed to open a position. In the example above, the required margin is $3,000.

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Understanding Leverage

Leverage is money borrowed from a broker to increase the amount one can use to trade forex. It increases a trader’s trading power when using a margin account.

With this increased trading power, traders can open positions much larger than the amount they have in their trading accounts.

It is written as a ratio in the form of “X:1”, so you might see a leverage of 100:1 in a forex trade. With the margin requirement of 2% for a $100,000 trade, you only need to deposit $2,000 to open a position. Your leverage for such a trade would be 50:1.

Leverage can increase a trader’s return from a favorable movement in forex, but it can also magnify losses at the same rate as it amplifies profits.

For this reason, it is crucial to have strategies in place to and strategies for managing risks to minimize losses when using leverage.

The Relationship Between Margin and Leverage

Margin and leverage have an inverse relationship. If the margin requirement is low, then the leverage is higher.

A broker will limit a trader’s leverage by altering the margin requirement. In currency pairs that fluctuate wildly, the broker can increase the margin requirement to 5% and even beyond to ensure that the trader is not , leading to massive losses.

Margin in Forex and Securities

Margin in forex and securities is very different. In securities, it is the money you borrow to pay for a stock, bond, or other security. If you do this, you will be buying on margin, as it is known in the industry.

To think about it another way, margin when buying securities is a loan you get from a broker that has to be repaid depending on the terms you both agree to.

Conclusion

Understanding margin and leverage is very important for traders. This is especially because doing so will help them know when they are taking undue risks and where there is a high risk of amplifying their losses if things do not go as expected. It will also help you understand the terms used by a broker when discussing helping you trade forex.