Leverage and margin are the terms each trader starts with. The concept is simple, so even a beginner trader will catch on fast. However, there are pitfalls that may affect traders’ positions if they don’t consider crucial points. We summed up the useful information that will make your margin trading effective and prevent you from making mistakes that may cost a fortune.
Leverage: Should You Borrow From a Broker?
The term leverage is quite simple and usually doesn’t raise questions in traders’ minds. Simply stated, leverage is a loan that a broker provides to traders so that they can increase their position size. However, you should remember that the loan is not for a precise term. You don’t own borrowed money and cannot use it to purchase an asset.
Leverage is a loan that a broker provides to traders so that they can increase their position size. However, a trader doesn’t own these funds.
Here, we should mention the term lot size. The standard lot size is $100,000. This means that if you want to trade one lot, you need to have $100,000. But what percentage of people have such a vast amount of money? Even if you choose smaller lot sizes – a mini lot of $10,000 or a micro lot of $1,000, odds are you won’t be able to provide the entire amount.
A lot size affects the amount you could earn. A standard lot allows you to earn $10 per pip. If you trade a mini lot, you can make $1 per pip. A micro lot will let you earn $0.1 per pip. So, it’s clear why traders care so much about the lot size. However, not everyone has even $1,000. That’s why brokers provide investors with a so-called loan. For example, you have $100, but even a micro lot is $1,000. So, a broker offers you 1:10 leverage. As a result, you have $1,000 and can open a position. Each broker chooses a unique amount of leverage. The smallest one is 1:5. This means that your own money will be multiplied by 5. The largest one is 1:1000. So, your funds will be multiplied by 1,000.
Leverage Trading: How It Works
In common terms, leverage is the borrowed funds a broker provides a trader with. It looks like a bank loan. Nevertheless, it works differently. First, you don't have to pay the money back because you don’t own them. Second, your risks rise significantly. Here, lots of questions appear. Why do brokers provide traders with money if they don’t get it back or don’t get an interest rate? Also, why do the risks grow?
Leverage is accompanied by higher risks.
We are ready to answer these questions. If we talk about a broker's profit, we should understand that every broker gets a commission for every trade you open. So, they benefit from your open positions.
However, leverage is a two-way street. As for risks, you should understand the following rule. Imagine you have $100,000, and you earn $1,000. Here, your leverage equals 1:1, so your profit is 1%. If you have a 1:100 leverage, your profit will amount to 100%. Sounds good, doesn't it? However, the situation is similar to losses you may suffer. If you have 1:1 leverage, and you lose $1,000, your loss will be -1%. However, trading with a leverage of 100, you will lose 100% of your funds. It’s not so attractive anymore. For this reason, some brokers limit the leverage they offer to their clients. For example, the maximum leverage of Libertex is 1:30 for retail clients and up to 1:600 for professional clients.
What Assets to Trade with Leverage
Leverage is used not only in the Forex market. Traders can use leverage for different assets. For example, derivative investors apply for leverage to open larger trades. Also, you can trade CFD of oil, gold, and stocks via a broker. Here, you can also use leverage. Below you will see a list of the securities that are mostly traded with leverage:
- Currencies. Of course, currencies are the most popular assets for leverage trading. Every reliable broker offers leverage for currency pairs.
- CFD. CFDs are famous among traders because they provide an option to trade such attractive assets as gold, oil, and stocks that provide a significant reward.
- Derivatives.Derivatives are also highly used by traders. Leverage allows them to operate large positions with small expenses or even without them.
How to Choose Forex Leverage Wisely
We would like to share simple rules that will help you determine the perfect leverage that won’t hurt your funds in the case of losses.
- Step 1. Try different leverage ratios. The most effective way to minimize risks is to practice. It would be best if you remembered that higher risks accompany higher leverage. So, if you don’t want to risk a lot, you should choose small ratios such as 1:5, 1:10. If you are sure of your knowledge and expertise, you can select higher levels.
- Step 2. Lower your risks. It’s essential to lower risks while trading. For this aim, you can use trailing and limit stops.
- Step 3. Determine position size. The primary rule says a trader shouldn’t risk more than 1-2% of each trading deposit.
Which Leverage Ratio Is Best for Forex Trading?
There is no perfect leverage ratio. Otherwise, a wide range of them would not exist. We will give you an example of significant leverage and a small one. Comparing the results, you will be able to determine your perfect ratio.
- Small leverage. Imagine you have small leverage. One of the small leverages is 1:5. So, if you have $10,000, using the leverage, you will get $50,000. A mini lot allows you to earn $1 per pip. In our case, it will be $5 per 5 lots. Imagine, you suffered a loss of 50 pips. You would lose $250. It’s 2.5% of the position.
- Big leverage. We also have $10,000, but we want to increase the amount we may earn. Thus, we choose 1:50 leverage. As a result, we have $500,000. Now, we can trade five standard lots. However, now one pip will cost $10. As we bought five lots, one pip will cost $50. Let’s assume we lost 50 pips. Our loss will amount to $2,500. Now, it’s 25% of our $10,000.
Margin: How to Connect with Leverage
As you learn what leverage is, you should know about another term. It’s the margin. When we talked about the leverage, you could question: how can brokers provide such huge funds? It looks dangerous to provide every trader with lots of money. However, brokers know how to protect themselves - they use margin.
Margin is the minimum sum that should be in your account to open and maintain trades.
Margin is not a fee for a transaction; it’s just a broker’s insurance that you will be able to operate open positions. Margin is locked by a broker when you open a new position. A broker should have a guarantee that your balance won’t fall below 0.
Imagine you have $100, you need 1:1000 leverage to open a 1-lot position. Your $100 will be a margin, the minimum amount you need to open a trade, and maintain it. A margin size depends on the number of lots and leverage. The larger the leverage is, the smaller margin you will need to fulfill. If the leverage is expressed in a ratio, the margin is depicted in percentage to the full position size. The size varies from 0.25%.
Margin: How to Calculate
To calculate the amount of the required margin, you need to determine a percentage (or so-called margin requirement) of the position size (or notional value).
The required margin is calculated regarding the base currency of the pair you trade. It’s worth noting that if the base currency is different from your account's currency, the margin amount will be converted to the account denomination.
- If the base currency and account currency are the same. To get the amount of the required margin, you need to multiply notional value (position size) by margin requirement.
- If the base currency and account currency are different. To get a required margin, you need to multiply the notional value by the margin requirement. The result should be multiplied by an exchange rate between the base currency and the account currency.
Types of Margin
Margin is always seen in MetaTrader. However, if you look at the picture below, you will see that there are different types of margin terms. Let’s clarify each of them.
- Required margin. It’s the basic term. Required margin is an amount needed to maintain your open position. Each open trade has its own required margin that will be locked ahead. Let’s consider an example. Imagine you open a trade of the EUR/USD pair. You want to trade one standard lot of $100,000. A broker requires a 2% margin. So, your required margin will amount to $2,000.
- Used margin. Used margin is calculated as a sum of all the required margin of the open trades. This amount is not accessible to open new trades. In MetaTrader, this term will be expressed by one word – margin.
- Free margin. This term is placed in the trade window in MetaTrader. The idea is clear. Free margin is the amount you still have to open new trades.
Relationship Between Margin and Leverage
Simply stated, a margin account allows a trader to use leverage. To calculate leverage, you need to divide one by margin requirement. For instance, if the required margin is 2%, the leverage will equal to 50.
Inversely, to count the margin requirement, you need to divide one by the leverage ratio. For example, if your leverage is 1:100, the margin requirement will equal 1% because 1/100 is 0.01 or 1%.
Margin: Trading Example in Forex Market
Let’s consider an example of margin trading. Imagine you trade two currency pairs. These are USD/CAD and USD/JPY. You have $1,000, but you used a 1:10 leverage, so, you have $10,000.
The first trade is a mini lot of USD/CAD. The margin is 2%. The required margin will equal $200. The second trade is a mini lot of USD/JPY. The margin is 3%. So, the required margin is $300. In the end, we have a used margin of $500.
What Is a Margin Call?
A margin call is a level at which a broker sends a warning to a trader that their margin has reached a dangerous point (40% or lower). A broker warns a trader to either close a trade to limit losses or add funds to stay in the market. A broker can but doesn’t have to close the trader’s positions.
Here, we should mention one more term. It’s a stop out. It would follow a margin call if a trader didn’t listen to the first warning. Stop out is a 50% level or lower that signals the margin has reached a minimum allowed amount. Here, a broker will close the trader’s deals without any alarm to prevent the balance from reaching negative figures.
Benefits and Limitations of Leverage and Margin
Both terms have their own advantages and disadvantages. Let’s consider them to avoid mistakes.
Big funds. The main advantage of leverage and margin is an opportunity to operate larger funds than you have. As a result, you can open larger positions.
Larger losses. The main disadvantage of margin trading is the larger losses you will suffer when taking leverage.
More considerable profits. A larger position size provides an opportunity to gain more massive profits as lot size and pip value are interconnected.
Illusion. Another limitation you may notice is the illusion of significant funds. You should always remember how much money you have.
How to Minimize Risks
Limitations of margin and leverage directly relate to risks you may meet with. So, larger losses and an illusion of significant funds are the risks that may affect your trades' effectiveness. To minimize them, you have several options.
- Reliable broker. As we mentioned above, there is a wide variety of leverage ratios. It looks attractive that you can multiply your funds by 1,000. Still, you should remember that your risks will surge dramatically. Choose a reliable broker, such as Libertex, that will limit the leverage ratio with only safe ones.
- Stop loss. Although a broker uses a margin call and stop out, we recommend you avoid such situations. For this aim, you need to use stop-loss orders. Count the amount you can risk before you place a trade. But remember about wide and loose stop losses. A risk-reward ratio should not be less than 1:2.
- Take profit. This type of order can allow you to fix your potential profit before a trade turns against you.
- Strategy. Before you place an order, you should know how much money you can trade, so choose a position size wisely. Try different leverage ratios to define the perfect one that will suit the amount of money you have and the assets you want to trade.
Forex Margin and Securities Margin
Previously, we talked about the Forex margin. To make it clear, we need to clarify what securities margin is.
A securities margin is borrowed money, which is used to buy stocks, ETFs, or bonds.
The amount usually equals up to 50% of the asset price. Here, we can use the term “buying on margin.” For example, if you buy stocks, you take a loan from a broker. It’s considered a down payment and allows you to own the security you purchase. When we talk about the Forex margin, it’s not borrowed money. And you don’t purchase currencies to own them.
To conclude, margin and leverage are basic terms of Forex trading. They allow a trader to open positions no matter what amount of money they have. This option is attractive. However, traders should remember the risks they might face. To know how to use leverage and margin, you should practice. It’s wise to do it with the small leverages that Libertex provides. The perfect place to practice new techniques risk-free is our demo account.
Why to trade with Libertex?
- access to a demo account free of charge
- technical assistance to the operator 5 days a week, from 8 a.m. till 8 p.m. (Central European Standard Time)
- leverage of up to 1:600 for professional Ñlients
- operate on a platform for any device: Libertex and Metatrader
We gathered the most famous questions that every beginner trader has.
How Does Leverage Affect Margin?
Leverage and margin have an inverse relationship. To calculate a required margin, you need to divide one by the leverage ratio.
How Do You Calculate Margin and Leverage?
To calculate leverage, you need to divide one by the margin requirement. Inversely, to count the margin requirement, you need to divide one by the leverage ratio.
What Is the Best Leverage for Beginners?
We would recommend using 1:5 leverage that won’t increase the risk of losses significantly.
What Is 1:500 Leverage?
It means that the amount you have will be multiplied by 500. For instance, if you have $1000, you will get $500,000. It will allow you to trade five standard lots.
What Is Leverage in Simple Words?
Leverage is a loan or borrowed money that a trader gets from a broker to open larger positions. Still, a trader doesn’t own the funds.