September 07, 2017
The high leverage available in the forex market is one of the reasons why so many traders are attracted to this exciting market. However, many new traders still don’t know what leverage is, how it is calculated and what a margin closeout is.
Leverage is a loan provided by your broker, which is used to take advantage of price movements on a significantly larger transaction than your initial trading account would allow to open. The average daily price movement on the forex market, with daily price changes of around 1%, is relatively small compared to the equities market. This is the reason why forex allows trading on high leverage, as these small price changes translate to significant amounts of money on large positions.
Forex brokers typically offer leverage in the amount of 20:1, 50:1, 100:1 or even 400:1. For example, a 100:1 leverage means you can open a position worth $100,000 with just $1,000 of capital.
Margin and Leverage
To trade on leverage, you need to deposit a collateral for the loan provided by the broker. This is called the margin. You don’t need to worry about this, as the broker will automatically allocate a portion of your trading account as the margin for a position.
The amount of the margin depends on the size of the leverage that you’re trading with. Taking the example above, a 100:1 leverage requires a margin of 1% of the position size, i.e. $1,000 ($100,000 x 0.01). The following table summarizes the amount of margin required for different leverage sizes.
As you can see, trading with a 400:1 leverage requires only 0.25% of margin. While this might seem attractive, it’s important to know that a higher leverage also comes with a higher risk. If a leveraged position goes against you, this will significantly increase your loss as well. Leverage amplifies your potential profits, but also amplifies your potential losses!
Margin calls, or margin closeouts, occur when your leveraged position against you, and your total trading account is in danger to fall below the margin required for the position. Your broker will automatically calculate this for you, based on your Net Asset Value (NAV) and unrealized gains/losses of the open position.
If a margin call happens, your broker will automatically close all open positions at the current rate, and all that is left in your trading account will be the margin. For example, let’s say you open one lot, which equals to $100,000, on a 100:1 leverage with a trading account of $3,000. Your broker will automatically allocate $1,000 of your trading account as the margin, and you will have $2,000 left as a “free margin” to take other trades and to withstand price fluctuations. If the position goes against you, and the unrealized loss exceeds your free margin, you’ll receive a margin call.
The Risk of a Highly-Leveraged Trade
The move of the GBP/USD pair after the Brexit vote, for example, could easily wipe out your account if you had an open buy position during that time without a stop-loss. With a fall of 1,000 pips, let’s see what would have happened to your $10k trading account. Assuming you had a long position worth $100,000 on a 100:1 leverage, the margin allocated for opening this trade would amount to $1,000. You still have $9,000 of free margin. But, this position size carries a pip value of around $10 per pip, and the 1,000 pips fall translates into a $10,000 loss. You would have received a margin call even before the fall in price came to an end. This example shows you not only the danger of trading on high leverage, but also the necessity of stop-losses in trading.
Higher Leverage Increases Transaction Costs
Trading on high leverage also carries higher transaction costs. A larger position size has a higher dollar-value per pip, which increases the cost of spreads in trading. For example, a spread of 2 pips equals to $20 of transaction cost on a position size of $100,000. You need to take this into account when defining your trading plan and the position size you’re planning to take.
Test Your Knowledge: What is Leverage in Forex?
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What is Leverage in Forex?
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Question 1 of 3
____ is a loan provided by your broker, which is used to take advantage of price movements on a significantly larger transaction than your initial trading account would allow.Correct
Question 2 of 3
Name the action that occurs when your leveraged position goes against you, and your total trading account is in danger to fall below the margin required for the position.Correct
Question 3 of 3
Higher leverage does NOT increase transaction cost.Correct