Forex Leverage and Margin Explained
In this step-by-step guide, we will aim to answer all the questions you may have about two extremely important concepts in both Forex and CFD trading; leverage and margin.
We will start by covering what leverage and margins mean in regard to forex trading, then we’ll look at how to use these concepts to your advantage as part of your trading strategy. We’ll also think about your risk management approach. Finally, we will explore whether you really need Forex leverage and margin in your trading.
So first let’s start from the beginning. It’s important to know that most brokers offer leverage to their traders. By leveraging their market position, Forex traders can increase their profit potential significantly but, like all good things in life, reward comes with risk.
What Is Leverage?
In the context of currency trading leverage refers to the use of trading credit, given to you by the broker, to acquire a larger market position than would be possible with your own limited trading capital.
Leverage is expressed in a ratio of X:1. The X symbolizes how many times the broker will match your trading capital with trading credit.
For example, when a broker offers a leverage ratio of 100:1, this means that for every $1 you invest in a market position, you can increase the size of your position a hundred-fold. With $1, you would have a market position worth $100.
In contrast, if a broker offered leverage of 1:1, you would need to invest $100 to hold a $100 market position.
The leverage that is available to you varies from broker to broker. In the forex trading industry, the leverage offered by brokers ranges from around 100:1 to 400:1. In some countries, however, leverage is limited by regulatory bodies. For example, EU brokers that are regulated by CySec are only allowed to offer a maximum leverage of 30:1.
The Pros and Cons of Leverage in Forex Trading
With a larger market position, you can amplify your profit potential based on the amount of leverage. However, this can be both beneficial and potentially risky, as leverage enables you to:
- Increase the size of your holdings which in turn will increase your overall market gain
- Accrue larger losses than your original capital, when the value of his market position decreases below his original market entry price.
Additionally, some brokers offer high leverage ratios of over 400:1, which is considered to be extremely dangerous, as it can lead to huge losses. As a result, some regulatory bodies will only allow for lower ratios.
What Is Margin?
Now we’ve got to grips with leverage, let’s assume you have a trading balance of $1,000 in your account. You want to invest in the EUR/USD currency pair, and your broker is offering you a leverage ratio of 100:1 on this market. Can you hold a position worth £100,000?
Simply put, no. You cannot fully utilize the amount of $100,000 until you have enough available margin in your trading account.
Margin refers to the amount of money which you must deposit to cover the credit risk of leveraging. However, most of the time you’ll be looking at your available margin. This is the amount of your account balance which you can trade with.
Brokers will usually express margin requirements as a percentage of the trader’s position. The value of the margin is not absolute, however, as it fluctuates according to the value of the trader’s market holding.
In our example above, the $1,000 in your trading account represents your margin. This means that the broker has requested a 1% margin requirement. However, as this is your complete account balance, it’s possible that this isn’t all available.
When you open a new trade, the broker holds the margin percentage. If you open too many trdes at any one moment in time, you will be limited in opening new ones, as there will be no margin left in the trading account.
Margin calls occur if the amount of money in your account falls below the broker’s margin percentage. You will receive a demand from the broker to top up your account until the required margin percentage is satisfied. Alternatively, you can liquidate some of your positions to cover the margin.
Do note, that if you fail to act in time, your broker may close all or some of your positions at their market price.
The Relationship Between Leverage and Margin
Margin and leverage go hand in hand, as you cannot trade with leverage without having margin. As the two above sections explain, leverage and margin have an inverse relationship. They both refer to the same thing, but from a different perspective.
The relationship between the leverage ratio and margin can be summarized in the following two formulas:
- Leverage = 100/Margin Percentage
If the margin offered by the broker is 2%, for example, then the leverage ratio is 50:1 (100 ÷ 2 = 50).
- Margin = 1/Leverage
A leverage ratio of 50:1 will yield a margin percentage of 2% (1 ÷ 50 = 0.02)
In the table below we’ve listed some of the most common leverage ratios and margin percentages:
|Leverage Ratio||Margin Percentage|
How to Use Leverage & Margin
To start using leverage and margin effectively, you first need to work out your total equity. In forex trading, equity refers to the total amount of money that is available in your trading account in addition to the unrealized profits and losses in your open positions.
Because your total equity depends on your open positions as well, it is constantly changing due to changes in the market prices. To calculate equity, you can use the following formula:
Total equity = Available funds + unrealized profits/losses in the open positions
For the sake of this example, however, we will imagine that you have just opened a new trading account. You have deposited $100 and not yet placed any trades. As such, your total equity is $100.
Next, you need to work out your available margin. Usually, your available margin will depend on what other open positions you have. At the moment, however, as you are yet to start trading, your available margin still stands at $100. Your account looks like this:
Account Balance: $100
Available Margin: $100
You go to make your first trade. You wish to sell a position worth €5,000, at the market price of $1.10, and the broker’s margin requirement is 1%. How much available margin do you need?
Margin required = Trade volume x market price x margin percentage
(€5,000 x $1.10 x 0.01%) = $55.00
You place the trade and your required margin now becomes your used margin. With only one position open these figures are the same. Your account now looks like this:
Account Balance: $100
Used Margin: $55.00
Available Margin: $45.00
With your trade open, you watch the graph, daydreaming about what you’ll spend your profits on. But what’s this? The graph is moving in the wrong direction and the market price has changed. EUR/USD is now trading at $1.11
If the market price of a currency pair changes whilst your trade is still open, the value of the trade changes too. This impacts your required margin, your profits/losses, and your available margin. Let’s run the numbers again:
Margin required = Trade volume x market price x margin percentage
(€5,000 x $1.11 x 0.01%) = $55.50
As you were hoping the EUR/USD price would fall, yet it increased, you are currently making a loss on this trade. Losses and profits that are still in flux are referred to as ‘floating profit and losses’. These always need to be considered, as they contribute to your available margin.
To calculate your current floating profit/losses, you need to work out by how much the price of the trade has changed by (in our example 1.1000 to 1.1100 would be a 100 unit change. These units are called pips in forex trading).
If each pip is worth $0.10, the change is worth $10, and so you have a floating loss of $10:
Floating P/L = (Current Price – Entry Price) x 10,000 x $X/pip
(1.11 – 1.10) x 10,000 x $0.1 = 10
Your account now looks like this:
Account Balance: $100
Used Margin: $55.50
Floating P/L: – $10
Available Margin: $34.50
With $34.50 leftover in your available margin, you could technically continue placing trades worth up to $3,450 (as the broker offers a leverage ratio of 100:1), but this wouldn’t be wise.
Your open positions impact your available margin constantly. As such, it’s recommended that you never utilize all your available margin at one time, as one bad trade could wipe out your account.
Who Should Use Leverage & Margin?
While utilizing leverage properly can increase your profit, it is actually a double-edged sword as you can also lose more than you have invested. In reality, however, you will almost definitely use leverage and margin during your trading career.
This is because forex trading without leveraging cannot be done on a retail scale without requiring a huge amount of capital. What’s more, even if you had a huge amount of capital, you wouldn’t want to put it all on the line.
One way to manage your risk when trading is to never overtrade. Overtrading occurs when a trader opens too many trades, in the same direction on margin, at the same time. Another way is to only trade with the very best forex brokers.
Choosing a reputable, high-quality broker gives you access to responsible levels of leverage. With these brokers you won’t be forced into placing riskier trades than you’d like, and your available margin will always be displayed clearly and updated immediately.
To start forex trading with leverage and margin, we recommend that you first compare top brokers to find one which suits your trading style and budget. Beginner traders should look for one which offers low leverage levels and a decent demo account, as with this you can practice trading for free before plunging into a real-money situation.
Is margin and leverage the same?
No, although they are connected. Leverage is the credit a broker gives you to control large positions. Margin, on the other hand, is the percentage of the total trade value which you must give to the broker. So, for instance, if you wanted to hold a position worth $100,000, and the broker offered you leverage of 100:1, you would need $1,000 worth of margin.
How is Forex leverage calculated?
Forex leverage is calculated based on ratios. For example, with a leverage ratio of 100:1, the trader can leverage his position by a hundred times.
Which leverage is best in Forex?
There is no best leverage in Forex trading as it all depends on your trading experience, your total equity, and market conditions. Larger leverage ratios have higher risks involved, whilst smaller leverage ratios limit your profit-making opportunities. Beginner traders should stick to leverage ratios of no larger than 50:1, as this minimizes the risk of wiping out your account in a single bad trade.
Can I trade Forex without leverage?
Theoretically it is possible to trade without leverage, however, this is not a practical option for most traders. Trading profitably without leverage requires a huge amount of capital. If you try to trade without leverage, with a small amount of capital, you would find that your profit-making opportunities are so limited that it’s simply not worth the risk.
Other educational materials
- What is a Margin Call?
- Setting Up a Chart in Metatrader 4
- Forex Trading Accounts and the Value of a Pip
- The Importance of Swap and Spreads
- How to Enter/Exit a Trade
Recommended further readings
- “Leverage and Market Stability: The Role of Margin Rules and Price Limits” Chowdhry, B., & Nanda, V. (1998). The Journal of Business, 71(2), 179-210.
- “Leverage aversion and risk parity” Asness, Clifford S., Andrea Frazzini, and Lasse H. Pedersen. Financial Analysts Journal 68, no. 1 (2012): 47-59.