Understanding Leverage When You Really Don’t

The advantage of leverage is what makes forex trading so exciting. If you are exhausted with such jargon and have been asking people to ELI5 (explain it like I’m five), this article’s for you.

Is it margin or is it leverage? Is it margin requirement or leverage ratio? Who knows and who cares, right? Wrong. Leverage is a double-edged sword. You must be thinking there we go again! But we’re very serious about this one. Leverage can increase both your profit potential as well as your potential losses, if the markets move the wrong way.

This is why you really need to know how leverage affects your trading positions and your capital. There are plenty of other benefits of understanding the concept, like better money management, risk management, trading strategies and long-term positive outcomes.  So, ready to get started?

  • What is Leverage and Why is it Important? 

    In the simplest terms leverage in forex is a loan you take from your broker. No, you don’t actually receive any cash. It is simply a line of credit extended by your broker, which allows you to enter a larger trading position.

    This means that with small capital from your end, you gain exposure to a large position size. Let’s understand this with an example.

    Suppose you opt for a 100:1 leverage ratio. This means that to open a position worth $100,000, you only need to use just $1,000 of your own funds. The broker will fund the rest of the position. This $1,000 then becomes the margin that you need to maintain in your account for the position to remain open.

    What is Margin?

    Margin trading is often confused with leveraged trading. To explain it, let’s get back to the earlier example.

    Firstly, you need to open a margin account to start trading. The $1,000 deposit is the initial deposit you had to pay to use leverage. This is the money your broker will require as a “good faith” gesture to open and maintain your leveraged position.

    Margin is expressed as a percentage of the total value of your position. In the case where you deposit $1,000 to open a position worth $100,000, the margin requirement is 1%. If the broker has a margin requirement of 2%, it means a leverage ratio of 50:1 and 5% would mean a ratio of 20:1 and so on.

    There are many different types of margin-related terms that you will encounter. Breathe, it’s not as complex as you might think. Let’s break it down for you in simple terms.

    • Initial Margin: The deposit in “good faith” we just talked about. 
    • Maintenance Margin: This is the amount you have to maintain in your trading account, to keep your position open.
    • Usable Margin: This is the capital in your account minus the maintenance margin. As long as you have usable margin, you can open new positions.
    • Margin Call: In case your losses erode your capital to below the maintenance margin, your broker will be unable to keep your positions open. If this happens, you will receive a margin call to deposit more money in the account.

    So, while leverage and margin are interconnected, they are not the same thing. Margin is the amount the trader needs to contribute towards the trading position.

    Top Tip: Monitor your positions and the capital in your trading account to avoid margin calls. Better yet, be careful where you place your stop loss orders to close your positions before losses mount up.

    How Leverage Works 

    Leverage is almost like taking a loan to buy a house. The bank says it will fund 80% of the total amount needed to buy the home, so you need to fund the remaining 20%. Leverage works similarly. 

    You want to go long on the USD/JPY but you don’t have $100,000 to fund the standard lot size. Your broker, like the bank, offers to fund 99% of the total amount, so you need to fund the remaining 1%. This is represented as a leverage ratio of 100:1. 

    In simpler terms, the broker is offering to put in $100 for every $1 you put into the trade. Now, if they said they would put in $500 for every $1 you deposit, it would be a leverage ratio of 500:1.

    When your position earns a profit, your earnings are calculated based on the entire position of $100,000, rather than just the $1,000 you funded. That’s what makes leverage so attractive.

    But, remember we said it’s a double-edged sword? So, here’s the catch with leverage. There are times when the markets move unpredictably or a sudden event causes volatility. Now, if the USD/JPY tanks in such circumstances, your losses will also be calculated on the total position size of $100,000, which would be much higher than for $1,000.

    This is why leverage is great but it has to be used with caution, knowledge and killer risk management measures.

    Top Tip: While you will find forex brokers offering high leverage, we advise caution. Leverage can wipe out your entire account, if the market so much as sneezes or has a small hiccup.

    Is There a Best Leverage Level?

    There is no such thing as the best leverage for forex. It depends on your trading strategy, risk/reward ratio and your knowledge of the upcoming market moves that determine your decision. For instance, scalpers can make a decision to use higher leverage than position traders, since they look for small and quick trades.

    Leverage needs to be chosen carefully, as it increases risk. Leverage ratios of 500:1 are not for the faint-hearted.

    However, with proper risk management tools, it is possible to minimise risk. There are robust risk management tools available on the best trading platforms like MT4, such as stop-loss and take-profit, which are indispensable when using leverage.

    Top Tip: When you begin using leverage, start small. You can always raise the leverage ratio as you gain experience and fine-tune your trading strategy.

    For more such useful insights, fun facts, and tips, follow us on Facebook and read more of these blog posts. Ask us any questions about using leverage to your advantage.

    What is Leverage and Why is it Important? 

    In the simplest terms leverage in forex is a loan you take from your broker. No, you don’t actually receive any cash. It is simply a line of credit extended by your broker, which allows you to enter a larger trading position.

    This means that with small capital from your end, you gain exposure to a large position size. Let’s understand this with an example.

    Suppose you opt for a 100:1 leverage ratio. This means that to open a position worth $100,000, you only need to use just $1,000 of your own funds. The broker will fund the rest of the position. This $1,000 then becomes the margin that you need to maintain in your account for the position to remain open.

    What is Margin?

    Margin trading is often confused with leveraged trading. To explain it, let’s get back to the earlier example.

    Firstly, you need to open a margin account to start trading. The $1,000 deposit is the initial deposit you had to pay to use leverage. This is the money your broker will require as a “good faith” gesture to open and maintain your leveraged position.

    Margin is expressed as a percentage of the total value of your position. In the case where you deposit $1,000 to open a position worth $100,000, the margin requirement is 1%. If the broker has a margin requirement of 2%, it means a leverage ratio of 50:1 and 5% would mean a ratio of 20:1 and so on.

    There are many different types of margin-related terms that you will encounter. Breathe, it’s not as complex as you might think. Let’s break it down for you in simple terms.

    • Initial Margin: The deposit in “good faith” we just talked about. 
    • Maintenance Margin: This is the amount you have to maintain in your trading account, to keep your position open.
    • Usable Margin: This is the capital in your account minus the maintenance margin. As long as you have usable margin, you can open new positions.
    • Margin Call: In case your losses erode your capital to below the maintenance margin, your broker will be unable to keep your positions open. If this happens, you will receive a margin call to deposit more money in the account.

    So, while leverage and margin are interconnected, they are not the same thing. Margin is the amount the trader needs to contribute towards the trading position.

    Top Tip: Monitor your positions and the capital in your trading account to avoid margin calls. Better yet, be careful where you place your stop loss orders to close your positions before losses mount up.

    How Leverage Works 

    Leverage is almost like taking a loan to buy a house. The bank says it will fund 80% of the total amount needed to buy the home, so you need to fund the remaining 20%. Leverage works similarly. 

    You want to go long on the USD/JPY but you don’t have $100,000 to fund the standard lot size. Your broker, like the bank, offers to fund 99% of the total amount, so you need to fund the remaining 1%. This is represented as a leverage ratio of 100:1. 

    In simpler terms, the broker is offering to put in $100 for every $1 you put into the trade. Now, if they said they would put in $500 for every $1 you deposit, it would be a leverage ratio of 500:1.

    When your position earns a profit, your earnings are calculated based on the entire position of $100,000, rather than just the $1,000 you funded. That’s what makes leverage so attractive.

    But, remember we said it’s a double-edged sword? So, here’s the catch with leverage. There are times when the markets move unpredictably or a sudden event causes volatility. Now, if the USD/JPY tanks in such circumstances, your losses will also be calculated on the total position size of $100,000, which would be much higher than for $1,000.

    This is why leverage is great but it has to be used with caution, knowledge and killer risk management measures.

    Top Tip: While you will find forex brokers offering high leverage, we advise caution. Leverage can wipe out your entire account, if the market so much as sneezes or has a small hiccup.

    Is There a Best Leverage Level?

    There is no such thing as the best leverage for forex. It depends on your trading strategy, risk/reward ratio and your knowledge of the upcoming market moves that determine your decision. For instance, scalpers can make a decision to use higher leverage than position traders, since they look for small and quick trades.

    Leverage needs to be chosen carefully, as it increases risk. Leverage ratios of 500:1 are not for the faint-hearted.

    However, with proper risk management tools, it is possible to minimise risk. There are robust risk management tools available on the best trading platforms like MT4, such as stop-loss and take-profit, which are indispensable when using leverage.

    Top Tip: When you begin using leverage, start small. You can always raise the leverage ratio as you gain experience and fine-tune your trading strategy.

    For more such useful insights, fun facts, and tips, follow us on Facebook and read more of these blog posts. Ask us any questions about using leverage to your advantage.

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