Understanding Leverage & Margin
Leverage and margin are some of the most important aspects to comprehend before embarking on your financial markets’ journey.
It’s fairly certain you have heard of the notions before, but are you sure you truly grasp the relationship between them and know which leverage and position size is right for you? Let’s lay out the basics!
What is Leverage?
When it comes to financial markets, leverage allows you to trade higher volumes, without putting up the full amount of collateral required. In other words, it permits you to make bigger trades by “borrowing” balance from your broker.
The good thing about leverage is that you may only put in part of the needed amount, but your profit will be based on the total value of the position. Nevertheless, keep in mind that so will your loss.
Leverage in Forex and CFDs trading is expressed as a ratio. Fondex, for instance, offers comparatively high leverage of up to 1:500. To take a look at how it works:
With leverage of 1:500, every $1 you have can trade up to $500. This way, if we assume you invest $1,000, you will be able to trade for $500,000.
What is Margin?
Now, when it comes to Forex and CFDs trading, you must have noticed that you are only required to put up a small amount of your capital to open a new position. This capital is what is known as your margin. To give a practical example: if you are buying $50,000 worth of EUR/USD, you don’t need to put up the whole amount, but rather a very minor portion of it. This minor portion is your margin.
Simply put, a margin is a good faith deposit/collateral used to open and maintain a position. Despite much confusion, it is not a fee or a transaction cost, but rather an amount your broker sets aside in order to keep your trade open and make sure that you are capable of covering potential losses from your trade.
Calculating your Required Margin
Let’s take a look at an example to calculate your margin. We assume you have a leverage of 1:30 and bought 0.20 lots or 20,000 units of EUR/USD at 1.10089. The collateral required to fund this position is then: 20,000*1.10089 = $22017.9. Now, if you divide the total position amount by your leverage, you get your required margin.
Required Margin = (Bid or Ask Price (Sell or Buy Price) * Lots) / Leverage = $22017.9/30 =$733.9
Understanding Margin Call & Stop Out Level
A margin call is a warning issued by your broker, alerting you of your available equity falling below the level necessary to maintain your positions. Your options during a margin call, therefore, are either to close your least profitable trades to free up some equity for your other positions or fund your account to support all of them.
Following a margin call, a stop out level is reached, at which your positions start to get closed automatically. A margin call and stop out level can be the same percentage, but also different, depending on your broker.
Advantages & Disadvantages
Now as we have seen, leverage and margin go hand in hand. So what are the advantages of trading with leverage VS without, and which is the right option for you?
Pros of Trading with High Leverage
1. Opportunity to trade with low capital
If you think about it, it’s questionable where the forex industry would be today if leverage didn’t exist. Prior to leverage, only very wealthy investors had the ability to be involved in the financial markets, while the rest had no chance of even making it in. Leverage grants any trader a shot in the financial arena.
2. A chance for higher potential profits
Logically, as leverage implies trading with “bigger money”, it also means higher potential profits if the market is moving in your favour.
3. Exponential account growth
Leverage grants small retail traders the opportunity to grow their accounts at a considerably quicker pace, trading multiple markets during the day, entering more trades and hence potentially growing their account in exponential progression.
4. Leverage is interest-free
Not to be confused, although we previously mentioned that leverage is something like “borrowing” funds from your broker, unlike in the case of a bank, you are not expected to pay interest.
Cons of trading with high leverage
1. A chance for higher losses
It’s a two-edged sword. Truly, if you win when trading with high leverage, you win a lot bigger, but the same happens when you lose. Trading with higher leverage means always keeping your finger on the pulse and not hesitating too long to close a position when the market goes against you.
2. Margin call risk
There’s always a risk that you may fall under the margin requirements, which may result in a margin call and the liquidation of your positions (which, if yielding profits, could be closed well before their time). It’s important to remain attentive to your margin levels.
Nobody said it would be easy! Depending on your psychological type, you may find it stressful to have too large of a position open, and the fluctuations of your unrealized profits and losses may make you fidgety. We mentioned before that when it comes to trading decisions, there is no room for emotion. Think if you are able to handle the pressure and, if not, you can always start off with smaller position sizes.
It’s wise to remember that leverage tends to influence us psychologically. Just like driving a race car, as opposed to a family van, it makes a trader feel braver to make risky decisions, but also exposes him to more danger.
Truly, leverage can grant us good chances for potential profit, but it’s wise to remember that the higher the potential win, the higher the risk too. Cautiousness and attentiveness to your portfolio is a “must” when trading with leverage. At the end of the day, the safety and security of you and your funds should always remain the number one priority.
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