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Forex Leverage And Margin Basics

A currency account is ready for trading once cash is deposited in the account. This cash is considered as margin money, the amount that needs to be in the account to trade one currency lot. Traditionally, a lot means $100,000 in the foreign currency. Margin is a monetary deposit that you provide as collateral to cover any losses. All dealers establish their own margin policy based on a percentage of the lot size. Normal margins range from 1% to 5%. For example, if the margin for day trading is 1% (100:1) with a dealer that offers lot sizes of $100,000, you may open a one-lot position with $1,000 in your Forex account. The requirements for margin vary with account size, and may be changed from time to time at the sole discretion of the dealing desk, based on volume traded and market conditions. As the account size and the ability to trade more lots increase, the margin percentage may also increase.

Another way to describe a 1% margin rate would be as leverage of 100 to 1 or 100: 1. Forex brokers have varying policies on minimum margin amounts and offer a wide range of margin requirements. You can cven find 400:1 leverage nowadays. But the question is if this is a good idea? For example, trading one lot of the EUR/USD for a Buy at 1.8010 and closing the position at 1.8140 represents a gain of 30 pips - and the market can move many times that in one day - for a $300 net profit. Trading at 100:1 leverage, that one trade would have provided a 30% return on margin. However, leverage cuts both ways. If the market were to move against you, your entire $1,000 account could be wiped out in a matter of minutes.

Use of Leverage

If you have been at all exposed to the world of Forex, you have probably heard the word Leverage being tossed around. But what exactly is Leverage? Leverage is a very important part of Forex trading, and it is critical that you know exactly how it works and how to use it. It is the term Forex traders use to refer to the ratio of invested amount relative to the trade's actual value. Forex Brokers usually provide their customers with the option to trade on borrowed capital, so that traders do not have to invest tens of thousands of dollars for the chance to make any real profit. When you trade at a leverage of 100:1 (or "100 to 1"), it means that for every $1 that you invest in the market, the broker invests $100 for you. As a result, you can control an amount of $50,000 by investing $500. Some brokers provide trades with the opportunity of trading at up to 400:1 leverage. It probably will not surprise you when we say that with greater opportunity for profit comes greater risk. Just like slight fluctuations in currency rates can make you significant amounts of money, it can also cause you to lose your money very quickly. The higher the leverage, the larger the profit that you stand to make and the quicker you might lose your investment. A leverage of 400:1 can make you more money than a leverage of 100:1, but it also puts your initial investment at more risk. If you trade with a leverage of 100:1, the market would have to move 100 pips against you for your position to be wiped out. On the other hand, if you trade with a leverage of 400:1, the market would only have to move 25 points against you for your position to be wiped out.

The Ratio between Lot Size, Trade Size and Leverage

The advantage of trading with leverage is that your profit potential is virtually infinite. At majority of Forex accounts, any losses are limited to the amount of your initial deposit. Once the rate drops below the rate covered by your investment ‐ that is, the "Usable Margin" reaches zero ‐ the trade is automatically closed. Remember, leverage can be a trader's best friend when used carefully, and his worst enemy when used recklessly. It is a great tool for increasing profits, in fact private traders rarely trade without it. But you should always keep in mind that the higher the leverage is, the higher the risk level is. Now that you are equipped with most of the basic tools, you can make your first trade! A simple trade example you may find below.

It's time to trade! (or for an example)

Let's say that after spending some quality time looking at the charts of several currencies, you´ have concluded that for example GBP/USD is trending up. Now what is the reasonable decision based on this conclusion? Clearly you can profit by buying GBP/USD (buying GBP/selling USD)

Reminder - buying is done at the "Ask" price, while selling is done at the "Bid" price.

Imagine that you bought 1 lot of GBP/USD on your Forex account. The details of your trade are:

Margin used: $25

Transaction size: 1 lot or 10,000 great british pounds

Leverage: 400:1 (10,000/25 = 400)

GBP/USD (Ask): 1.3956

In plain English, what you have just done is bought 10,000 units of GBP/USD, which at that specific rate represents 1.3956 USD per 1 GBP.

Now, let's assume that at the end of the day, or possibly even a few minutes later, the GBP/USD rate has risen to 1.4066. You sell those 10,000 GBP/USD Units at the new rate of 1.4066 and get $110 back. This means that this seemingly insignificant fluctuation in the rate allows you to cash in $110 on an initial used margin or investment of only $25. In other words, you just made significant profit on your investment, thanks to the movement in the exchange rate and the use of leverage.

On the example trade that we have just seen, your reward was unlimited, and the risk was limited to your deposited funds.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.