• Margin

• Leverage

• Advantage of leverage: much higher rate of return

• Disadvantage of leverage: you can quickly lose everything

In this article, I’m going to explain one of the big advantages that you get from trading the forex market through a broker, namely: margin and leverage.

Margin

Margin is the amount of money that an investor has to put up in order to own an asset. Think of it like the deposit on a house: generally, people don’t put down all the money that they need to buy a house, but rather put down say 10% and borrow the rest from the bank. 

It’s basically the same in the forex market. Usually, you don’t need to have the whole price of what you’re buying. You only have to put on deposit with your broker enough money to cover possible losses. The deposit you put up is called margin. The broker then in effect lends you the rest of the money and lets you trade a certain multiple of the margin. That frees up your money to put on more trades or bigger trades than you would otherwise be able to. You can therefore make bigger returns relative to the amount invested than if you just changed your money into another currency and waited. 

Leverage

That’s because the use of margin gives investors what’s called leverage. A lever allows someone to move heavy loads with a small amount of effort. Similarly, leverage allows someone to control a large amount of assets with a small amount of money. 

Leverage is usually expressed as a ratio, such as 10:1. This means that you can trade 10 times the amount that you put up for margin. So if you deposit for example $100, you can buy $1,000 worth of euros or pounds or whatever. Leverage can go much much higher though; some firms allow their traders to trade with leverage of 500:1, meaning that your $100 deposit would allow you to buy $50,000 worth of currencies. 

Advantage of leverage: much higher rate of return

Leverage can give you a much higher rate of return than what you could get otherwise. For example, let’s say you want to buy one standard lot of EUR/USD, or €100,000, with EUR/USD trading at 1.1000. You could of course deposit $110,000 USD and change it all into euros. But with margin trading, if you choose 30:1 leverage (the maximum allowed in the UK for major currency pairs), you only have to put up 1/30th of the total amount as margin. That would be $3,667. So with $3,667 you can trade as if you had $110,000 in your account. 

The advantage to this is that you get a much higher return on your capital. Let’s say again that you buy 1 standard lot of EUR/USD, or €100,000, with EUR/USD trading at 1.1000. If you remember what we said a few articles ago about pips, when you’re trading a standard lot of two currencies that are roughly the same value, the value of the movement of 1 pip is 10 units of the quotecurrency. So every 1 pip move in EUR/USD makes you $10 USD. Let’s say EUR/USD goes to 1.1100. That’s a move of 100 pips, or 100 times $10. You’d make $1,000.

If you put up the whole $110,000, then your $1,000 profit would be a little less than 1% of your initial investment. But if you used 30:1 leverage and put up only $3,334, then your would have made 27.3% of your initial investment. 

That’s why it’s called leverage. A small movement in your position makes for a big movement in your profit & loss statement. 

Disadvantage of leverage: you can quickly lose everything

Of course, leverage works both ways. In this example, if you’re using 30:1 leverage and EUR/USD falls 367 pips to 1.0633, your margin will be wiped out entirely and your position will be automatically closed out. You’ll lose all the money that you put up as margin. 

Actually, you’ll probably have a margin call well before then, meaning the broker will call you up and ask you to either put up more margin or close out your position. If you don’t have any more money to put in, you’ll get stopped out of your position automatically and your trade closed out at a loss, perhaps before you wanted it to be closed. 

But the good thing is, under normal circumstances you can’t lose any more than your margin. Your losses are limited while your potential profits are unlimited – assuming of course that the broker can indeed stop you out in time. 

I want to stress the phrase “normal circumstances,” because sometimes circumstances aren’t normal. Occasionally, if you’re trading with high leverage or if markets are moving very quickly, it’s not possible to close out your trade on time. The textbook example of this was on 15 January 2015, when the Swiss National Bank suddenly withdrew its guarantee that EUR/CHF wouldn’t go below 1.20. The pair immediately plunged to around 0.85 without any trades being done. In such a case, people trading on margin could well have been legally liable for more money than they initially put up. In fact several brokerage firms went bust on this occasion because their clients couldn’t afford to pay and the brokers got stuck with the bill. Note that a few brokers offer negative balance guarantees to clients in some jurisdictions. That is, for a price they will guarantee you that a trade will never go into negative balance – that you will never lose more than what you’ve put up for margin. This is an important risk management tool that you should consider when you’re trading, if it’s available. 

Leverage to improve diversification

Leverage has another useful function: it allows you to put on more trades and gain the benefit of diversification. For example, let’s say you had $1,000 to trade with. With 30:1 leverage you could buy $30,000 worth of EUR/USD. Or you could use 10:1 leverage and buy $10,000 of EUR/USD, $10,000 of GBP/USD, and $10,000 of USD/JPY. With good risk management – not waiting to get stopped out of the losing trades – you might make enough in one winning trade to make up for losing on the other two. 

Summary

We’ve discussed here the use of margin. Trading on margin involves depositing some money with a broker and in effect borrowing the rest to put on a trade. This allows traders to put on bigger or more trades than they would otherwise be able to do. This gives them leverage. The judicious use of leverage allows traders to take the same position with much less capital and to earn a higher percentage return on their capital, or to take more different trades with the same amount of capital, thereby spreading the risk. 

Of course, it works both ways – the more leverage, the less room for error there is.