The high leverage available in the forex market is one of the reasons why so many traders are attracted to this exciting market. However, many new traders still don’t know what leverage is, how it is calculated and what a margin closeout is.
Leverage is a loan provided by your broker, which is used to take advantage of price movements on a significantly larger transaction than your initial trading account would allow to open. The average daily price movement on the forex market, with daily price changes of around 1%, is relatively small compared to the equities market. This is the reason why forex allows trading on high leverage, as these small price changes translate to significant amounts of money on large positions.
Forex brokers typically offer leverage in the amount of 20:1, 50:1, 100:1 or even 400:1. For example, a 100:1 leverage means you can open a position worth $100,000 with just $1,000 of capital.
Margin and Leverage
To trade on leverage, you need to deposit a collateral for the loan provided by the broker. This is called the margin. You don’t need to worry about this, as the broker will automatically allocate a portion of your trading account as the margin for a position.
The amount of the margin depends on the size of the leverage that you’re trading with. Taking the example above, a 100:1 leverage requires a margin of 1% of the position size, i.e. $1,000 ($100,000 x 0.01). The following table summarizes the amount of margin required for different leverage sizes.
As you can see, trading with a 400:1 leverage requires only 0.25% of margin. While this might seem attractive, it’s important to know that a higher leverage also comes with a higher risk. If a leveraged position goes against you, this will significantly increase your loss as well. Leverage amplifies your potential profits, but also amplifies your potential losses!
Margin calls, or margin closeouts, occur when your leveraged position against you, and your total trading account is in danger to fall below the margin required for the position. Your broker will automatically calculate this for you, based on your Net Asset Value (NAV) and unrealized gains/losses of the open position.
Higher Leverage Increases Transaction Costs
Trading on high leverage also carries higher transaction costs. A larger position size has a higher dollar-value per pip, which increases the cost of spreads in trading. For example, a spread of 2 pips equals to $20 of transaction cost on a position size of $100,000. You need to take this into account when defining your trading plan and the position size you’re planning to take.