Advanced Forex Blog

What’s The Relationship Between Margin & Leverage?

November 7, 2021 | 5:03 pm | Advanced Forex Blog
November 7, 2021 | 5:03 pm
Advanced Forex Blog
What's The Relationship Between Margin & Leverage?

Margin vs Leverage

Are you looking to enter the world of forex?

Everyone is enthusiastic about forex these days, but many people are losing a lot of money because of the high leverage.

For all newcomers, forex leverage and margin might be puzzling, and we’re here to help! 

In this guide, we’ll explain what leverage and margin are in forex and what’s the relationship between the two. 

 

What is forex leverage?

Leverage refers to using a small proportion of your own money to gain power over a much greater sum of money. Typically, you obtain the funds from your broker. Margin trading is another name for leverage.

Before you create an account with a broker, be sure you know how much leverage you’ll be allowed to use. The larger the ratio, the greater the potential profit or loss. The most common ratios offered by brokers are 10:1, 50:1, 100:1, 200:1, and 400:1.

Before you start trading, you need to figure out how much leverage you’ll need. If you have a string of profitable trades, it might be quite tempting to trade in a larger size than what you originally choose. 

Doubling your risk on a one-time basis might benefit a trader if that one-time deal goes well. However, if you get it wrong, you might wind up with a far bigger loss than typical. To help limit risks in trading, you should go with your risk management strategy.

 

A double-edged sword

There’s an old saying that leverage is a double-edged sword. 

They were hinting that leverage had the potential to make or ruin your trading account. It can provide you the opportunity to make large quantities of money, but it can also take them away from you.

The more leverage you utilize, the higher the risk to your money.

Let’s use an example to illustrate this: 

Let’s say you’re long GBP/USD. Then, if the GBP/USD price goes from 1.3869 to 1.3969 (100 pips) in the coming week, you will profit $10 on each transaction with a $1000 account.

If the price goes to 1.3769 (100 pips) in the next week, you will lose $10 on each transaction. As a result, leverage is a two-edged sword.

 

GBP/USD

 

 

What is Forex Margin 

On the other side of Margin vs Leverage, there’s the margin.

When you initiate a position in the forex market, the margin is the amount of money you must deposit through your broker. 

There are different forms of margin in forex. Here is a quick review of them: 

Margin: The capital you put in is referred to as the margin.

Margin requirement: This is a number from your broker expressed as a percentage that tells you how much capital you can manage based on your trading capital. 

Used margin: The amount of your funds that your broker has used to control your positions is known as the used margin.

Usable margin: The amount of funds in your account that can be used to open new positions is known as usable margin.

Margin call: A margin call triggers when the money in your account is less than your potential loss. To compensate for the difference, your broker may close some of your positions.

A margin is a proportion of the total amount you control, and various brokers have varied margin requirements.

The amount of leverage a trader can use is determined by the broker’s margin requirements or the leverage limitations set by the relevant regulatory authority.

Margin requirements vary depending on forex brokers and the area where you open an account; however, for major pairs like GBP/USD, EUR/USD, and others, they typically start at around 3%.

For example, if a forex broker offers a 3% margin rate and a trader wishes to create a $100,000 position, just $3000 is required as a deposit to start the trade.

The broker would give the remaining 97%. The trade mentioned above has a 30:1 leverage. The amount of margin required grows in parallel with the size of the trade. 

 

What’s the relationship between the two?

Now that you know what forex leverage and margin are let’s move to the relationship between the two: Margin vs Leverage.

A trader is expected to put up a portion of the position’s worth in good faith when they initiate a position. The trader is starting a leveraged trade in this situation.

The margin requirement is the fraction element that is represented in percentage numbers. For example, 1%. The needed margin is the amount that must be put up entirely. 

One % of a $100,000 position size, for example, equals $1000. The needed margin to open this specific trade is $1000. Your leverage ratio is 50:1 since you can trade a $100,000 position size with only $1000.

Here’s how the relationship works: 

  • Leverage = 1 /margin requirement
  • Margin requirement = 1 / leverage ratio

This is how you can calculate leverage and margin for trading positions. 

Going back to our example, if the margin requirement for opening a position is 1%, then you can calculate leverage as:

Leverage = 1/0.01 = 1:100. 

Notice we use 0.01. Why? 

Because pips are used to measure currency changes, a pip (percentage in points) is the smallest unit of monetary movement. A pip is a price fluctuation of 0.0001 for most major currency pairs, such as GBP/USD.

When the GBP/USD currency pair goes from 1.4000 to 1.4100, it moves 100 pips or one cent, but it may yield big profits and high losses when you employ high leverage.

As you can see, leverage and margin are inversely related.

Leverage and margin are inversely related

 

Margin vs Leverage Bottom Line

Leverage is a strong weapon that can help you win big in the forex market, as we’ve seen. You can handle more positions with less capital, providing you more freedom and increasing your returns. It can, however, quickly increase your losses.

Leverage starts to hurt your chances of success at very high levels. This is because the bigger your position, the higher your trade costs are as a proportion of your margin. It means that with excessively high leverage, trading costs already put you at risk.

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