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Leverage and Margin Details Overview You Need to Know While Trading

Leverage and Margin Details Overview You Need to Know While Trading

What is Leverage?

Leverage and Margin Details Overview You Need to Know While TradingIn finance, leverage means borrowing funds to buy things (currency pairs in forex trading), estimating that your profit will get multiplied by the cost of your borrowing. This name comes from the lever in physics, which increases a small or tiny input force into a large output.

However, it also has high risk. If you don’t get the expected return or the price falls, you will have to return the money you have borrowed. That’s why the lender set the limit for leverage, meaning that you will need to provide collateral security for the borrowed money. That’s why you need to be good at forex trading analysis.

In short, you are controlling a larger position with a smaller forex market capital. It is expressed as a ratio, such as 50:1, 100:1, or 500:1. As the leverage increases, traders gain greater buying power, but this also amplifies the risk of potential losses.

Understanding Forex Leverage for Beginners

Let’s make you clear with an example.

Suppose you have $1,000 in your trading account, and you intend to trade the EUR/USD currency pair. The current exchange rate is 1.1000.

Without leverage:

If you were to trade without leverage in forex, you could buy 1,000 units of the base currency (EUR) with your $1,000. If the exchange rate increases to 1.1050, your position would be worth $1,105 (1,000 units * 1.1050). Your profit would be $5 ($1,105 – $1,000).

With leverage (100:1):

Now, let’s say you use 100:1 leverage. This implies that with every $1 in your account, you can control $100 worth of a currency pair.

With your $1,000 account, you can now control a position worth $100,000 (1,000 * 100).

In this case, you could buy 100,000 units of the base currency (EUR) instead of just 1,000 units. If the exchange rate increases to 1.1050, your position would be worth $110,500 (100,000 units * 1.1050). Your profit would be $500 ($110,500 – $110,000).

As you can see, using leverage in forex trading significantly increased your profit in this example. Nevertheless, it is crucial to bear in mind that leverage also enhances the risk of potential losses. If the exchange rate had decreased instead of increased, your losses would be magnified in the same way as your profits. It is always wise to exercise caution when utilizing leverage and to assess your risk tolerance before engaging in trading with high leverage.

Best Leverage in Forex

The perfect leverage in forex varies on trading types as well as the traders. For instance, conservative traders or new traders may consider 5:1 or 10:1 initially. On the other hand, seasons investors may consider taking high leverage. They can try 50:1 or even 100:1 plus. For your information, seasoned investors are risk friendly.

What is Margin?

Be Careful Trading On MarginMargin in forex trading refers to the funds a trader must deposit in their trading account to initiate and sustain a leveraged position. It serves as collateral or a security deposit, ensuring that the trader can cover potential losses incurred on their open positions. Margin trading is typically represented as a percentage of the total position size.

There are two main types of margins in forex trading:

  1. Required Margin (or Initial Margin): The minimum deposit required in your account to initiate a leveraged position is determined based on a percentage of the total position size. For example, if you want to open a $100,000 position with a 1% required margin, you would need to deposit $1,000 in your account ($100,000 * 1%).
  2. Maintenance Margin: To sustain an open leveraged position, it is necessary to maintain a minimum account balance. If the account balance drops below the maintenance margin level, your broker may issue a margin call, prompting you to either deposit more funds or close certain open positions in order to restore the account balance above the maintenance margin level.

Keep in mind that your broker will set the margin for you, and they also work on it to manage your account balance accordingly. However, margin trading can increase both profit and losses. Hence, it is highly important to use proper risk management techniques and observe your open position closely.

Besides the margin requirements, you will also notice other margin terms in your trading platform. Some of the popular margin terms are:

Account balance: This is just a phrase for your trading bankroll and it is the total amount of your money that you keep or maintain in your trading account.

Used Margin: This is the amount the broker has set aside to keep your position open.

Margin Requirement: This is the amount required by the broker to open a position.

Usable Margin: This is the amount of margin that you can use to open new positions with the broker.

Margin Call: You are entitled to this amount when you cannot cover the possible loss. This condition arises when your equity falls below your used margin.

What is Margin Trading?

Margin trading refers to the use of deposited capital to borrow more funds from the forex broker for trading purposes. However, margin trading may seem similar to leverage in forex trading. But there is a slight difference. Leverage trading uses a credit facility from the broker.

What is Free Margin?

Free margin means the trader’s available margin to open a position in the forex market. Therefore, it is equivalent to the trader’s ‘Equity’ – ‘Used Margin.’ So, free margin forex s not fixed and can increase or decrease as per the trader’s total profit or loss.

Margin Call in Forex

A margin call in forex happens if a trader’s account equity falls below the required maintenance margin level set by the broker. It is a kind of notification sent by the broker to traders. Traders are informed by brokers to either deposit additional funds or close some of their open positions, allowing them to restore their account equity above the maintenance margin level.

The margin call helps the broker and trader to protect from any potential losses because of insufficient funds. With margin call notification, trade can cover the open position if equity falls.

Margin Call Explained

Here’s a step-by-step explanation of how a margin call works in forex trading:

  1. Firstly, a trader uses a margin to open a leveraged position in forex. But before that, the broker sets the amount for the required margin as well as the maintenance margin.
  2. If the market moves against the trader’s expected position, it decreases the equity (account balance + floating profit/loss).
  3. If the decreased equity falls below the maintenance margin level, the broker issue a margin call for that account.
  4. Then, the trader gets the margin call notification, and the broker offers two options.
  5. Trader may deposit additional funds to increase the account equity and keep it above the maintenance level.
  6. Trader may also close some of the opened positions and reduce the margin requirement. This will also ultimately bring the equity back to the maintenance margin level.
  7. Despite the notification, if traders fail to take any suggested action, the broker may take action. The broker may close some of the trader’s position and stop any further losses. This is called stop-out.

Let’s consider an example to illustrate a margin call in forex trading:

Let’s say you have a forex trading account with a $10,000 balance. Your broker offers 100:1 leverage with a 5% maintenance requirement. Now, you take the decision to open a long position on EUR/USD currency pair and buy 100,000 units (1 standard lot) at a 1.1000 exchange rate. Hence, this position is worth $110,000.

So, the required margin with 100:1 leverage will be $1,100 ($110,000 / 100). On the other hand, the maintenance margin will be 5% of the value of the position. So, it will be $5,500 ($110,000 * 5%).

Now assume that the market moves against your position, and the EUR/USD exchange rate drops to 1.0950. So, the value of your position is now $109,500 (100,000 units * 1.0950), and your floating loss is $500 ($110,000 – $109,500). As a result, your equity on that forex trading account is now $9,500 ($10,000 account balance – $500 floating loss).

Therefore, your equity is below the maintenance margin requirement, which is $5,500. At this point, your broker will send you a margin call. Later, you will need to close some positions or add extra funds to your account to keep going your trading position.

In that case, you may deposit at least $1,000 into your trading account and increase your equity to $10,500 ($9,500 + $1,000). Now equity increased above the maintenance margin requirements.

However, if you don’t have money to deposit or if you don’t want to add extra funds, you may close a portion of your opened position. It will reduce the margin requirement. For instance, you may close half of the position, which is 50,000 units. Hence, the value will reduce to $54,750 (50,000 units * 1.0950) and the maintenance margin requirement to $2,750 ($54,750 * 5%). Consequently, your account equity will be restored to a level above the maintenance margin requirement.

Make sure you observe your account activity from time to time while also using adequate risk management techniques to protect your trading capital.

What is Trading Capital?

Trading capital in forex means the amount of available money in a trader’s account to open and maintain a forex position. In other words, FX capital is the financial resource a forex trader allocates for their trading positions, keeping the entry, exit, risk, and loss in their mind.

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