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What is Margin and Leverage?

by on January 14, 2014 3:51 pm GMT
 

Margin and leverage are key components to trading, but many traders fail to understand what these two key concepts are and how they effect overall success.

Forex brokerages issue various margin requirements, as it is different depending on the currency pair traded, to their clients. This sum of capital is a deposit, of sorts, to the brokerage that is held in the client’s account. A client must have his requirement in their account at the time of the trade and through its duration. The broker essentially lends the other portion of the cost of the trade within a margin account (there are non-margin trading accounts, too). This is done to relieve the brokerage for risks associated with a trade gone wrong, such as one that results in account liquidation.

A margin call is the result of the margin account’s value declines below the require margin issued by the broker. The broker will issue the margin call, and the trader can either deposit additional capital or close out the trade. The vast majority of brokerages have was risk management measures that will immediately liquidate trades when a margin call is issue to prevent further decline.

Leverage is a trader’s best friend but often their worst nightmare. It is a byproduct of margin that allows traders to trade larger sizes then they would with a cash account. Leverage is a magnifier to both returns and losses, and uncontrolled leverage is the result of margin calls and account liquidations.

Leverage can help smaller traders enter the market, but traders will often trade too large to the point where a small movement in the underlying asset will trigger margin calls.

Accounts can be issued various leverage multiples, but the United States requires account no to exceed 50:1, which is more than enough in many cases. Some non- or poorly regulated forex providers offer upwards to 1000:1 in leverage. This is a non-winning situation for the trader.

For instance, a trader has two trades on USDJPY. One trade is levered 10:1 (notional $10,000 in base currency) and another is leveraged 50:1. Both trades have a stop-loss of 100 pips (for the sake of the example). The two trades have hit their stop-loss. The trade levered 10:1 losses $1,000, wheres the trade levered to 50:1 losses 5x more at $5,000.

Traders must take into account the level of leverage issued on each trade. As humans, we have this need for instant gratification, so a trader will increase the margin to make more money for a smaller move. The trader wins a few times, and the utility to making x-amount on the previous trades increase because making the previous amount is no longer satisfying; so, leverage is increased again until a signal losing trade wipes out the account.

It’s a vicious cycle that leads to a path to nowhere. Leverage trading is beneficial when used with constraints.