Currency prices in forex move constantly but usually in very small amounts. The average daily moves of the most traded pair, the EUR/USD, for example is just 60-100 pips. If you invest with modest funds, then the amount you can make on successful trades will be very low. Leverage offered by brokers is like a loan that allows traders to take larger positions meaning greater profits. Once the deal is closed the ‘loan’ is returned to the broker and the trader keeps the profits. Leverage however not only magnifies wins, it also magnifies losses should the trade move against you.
Leverage is a very powerful tool that when popularly used in forex trading and CFD trading can be very rewarding. Read on to learn all about how leverage can transform a trader’s journey and why it’s important to use it very carefully.
A few terms commonly used when trading with leverage:
Leverage is expressed as a ratio of position value to the capital required. For instance, a leverage of 100:1 implies that a trader can take a position of $1,000 with only $10 from their own funds. The remaining $990 is borrowed from the brokerage.
Borrowing money to get a higher exposure to the chosen assets magnifies the trader’s profit potential. However, leverage works the other way too, as it increases the risk. If the value of the asset moves in an unfavourable direction, the trader not only loses his/her own money but also must return the money borrowed from the brokerage.
Margin is the minimum capital or account balance that a trader must have to use the leverage offered by the broker. In the above example, a trader must have at least $10 in their trading account, to enjoy the leverage. Often margin has two forms:
Used Margin: This is the security amount that a trader must deposit in their account held at the brokerage to continue with the opened position. The money technically belongs to the trader but can be accessed only after the leveraged positions are closed.
Usable Margin: This is the total capital present in a trading account, which may be much more than the amount required to use leverage for a position.
Did you know?
Using leverage is also known as margin trading or buying on margin.
In case the asset price moves in the opposite direction to what the trader predicted for an extended period, the losses made on the open position may be higher than the account balance or margin requirement. Such a situation triggers what is known as a margin call. It means that the trader is notified by the brokerage to either add more funds into their account or close their open positions.
Country regulations determine the maximum leverage that a brokerage operating in the region can offer. For example, as per the 2018 guidelines from the European Central Bank (ECB), the maximum leverage ratio that can be offered to retail traders for CFD trading in the EU is:
30:1 for forex trading on major currency pairs
20:1 for gold trading, major indices, and forex trading on minor currency pairs
10:1 for commodity trading (except gold) and non-major equity indices
5:1 for individual equities
2:1 for cryptocurrency trading
When trading with leverage, traders put in only a fraction of the actual value of the trade. The rest is provided by the brokerage. Let’s say a trader wishes to buy a stock that is worth $2,000. The broker offers leverage of 5:1 for this stock. This means the trader will need to pay only $400 to own this stock, by borrowing the remaining $1,600 from the brokerage. If the minimum margin requirement is 20%, the trader will need to hold $400 in their trading account to open the position.
If the trader’s has $1,000 in the trading account, $400 is the used margin and $600 is the usable margin.
Let’s assume that the price of the stock rises from $2,000 to $2,800.
With leveraged trading, when the trader sells the stock for $2,800, the $2,000 borrowed from the brokerage needs to be returned.
Let’s consider the scenario in which the asset price falls instead of rising. Let’s say the stock price falls from $2,000 to $1,800.
Leverage trading is a powerful tool to increase exposure and grow the trading portfolio. it is also the most popular way of accessing some markets that would otherwise have been inaccessible to retail traders. Here are some tips on how to use leverage wisely:
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