Leverage and margins

Beginner Questions
1

Hello Forex Traders. My name is Oratilwe from South Africa. I am currently working through the the school of pipsology and I should say I am loving it. I need help.

I am having difficulty understanding leverage and margins.

Leverage is defined by babypips from a dictionary "The textbook definition of “leverage” is having the ability to control a large amount of money using none or very little of your own money and borrowing the rest."

I get a feeling that the way I am understanding this is not the way it is applied. I am understanding leverage as money borrowed from a broker this feels like a wrong understanding.

What is leverage and margin and why are these two concepts important to my trading.

2

@SimplyOra

You are correct. The definition given, which involves borrowed money, is completely false.

Congratulations, for seeing this!

In the retail forex business, there are two types of leverage: (1) the maximum allowable leverage dictated by your broker, and (2) the actual amount of leverage that you use in any particular trade.

Both types of leverage involve the ratio between your position size and your account balance.

But, neither type involves borrowing money from your broker, or from anyone else.

(1) Maximum allowable leverage

If your broker specifies maximum allowable leverage of 100:1 (for example), he is saying that you may take a position size that is up to 100 times the size of your account balance.

If, for example, you have an account balance of $1,000 and your broker allows you to use up to 100:1 leverage, then you may take a position that is worth up to $100,000.

At no time has your broker offered to lend you money. He will never do that.

He is simply saying that, provided you have the minimum $1,000 or more in your account, he will allow you to make this trade.

Using this much leverage would be foolish, as you can probably work out for yourself by simply considering the implications of a normal price move against your huge $100,000 position.

(2) Actual amount of leverage you use in a particular trade

Let’s assume that you are not foolish, and would never use the 100:1 maximum allowable leverage offered to you by your broker.

Instead, you are sensible, and you use prudent risk management to determine the size of your position. You decide to risk no more than 1% of your account balance on a trade that you intend to take. Factoring in the stop-loss level which your charts suggest to you, you determine that a position size of 2 micro-lots (that is, 2,000 units of currency) is the appropriate position size. And you determine that the notional value of this position is $2,000.

You are now entering a $2,000 position with an account balance of $1,000. The actual leverage you are using is 2:1, because your position size is 2 times the size of your account. This position size is well below the maximum size allowed by your broker.

And, just as in (1) above, there is no borrowing involved.

So, what really is happening? How can you trade a larger position than your account balance?

Your position is very much like a bet. You are betting that a $2,000 position in a particular currency pair will move in a certain direction. In order for you to place this bet, your broker requires that you post MARGIN. Given your broker’s 100:1 allowable leverage, the initial margin required for any position you enter will be 1% of the notional value of your position. In the case of your $2,000 position (in the example above), this initial margin amount is $20.

As soon as your position is entered, this initial margin amount might change to an even lower maintenance margin amount, but let’s not consider that at this time. Let’s just say that, for the duration of this trade, the margin required is $20.

That $20 amount is escrowed, so to speak. It is set aside, out of your reach, although it is your money. It’s like a security deposit, to allow you to take this $2,000 position.

The rest of your account balance remains available for your use, including for use to cover losses (should they occur) in your position.

Your bet can have only 3 possible outcomes: it will produce a profit, it will break even, or it will produce a loss. If your bet produces a profit, that profit will be added to your account, in the currency in which your account is denominated, as soon as you close your position. If your bet breaks even, your account will be in the same condition it was in before you took this trade. And if your bet produces a loss, then that loss will be deducted from your account, in the currency in which your account is denominated.

So, no matter what currency pair you bet on, profits and losses (P/L) will appear in your account in the same currency that you originally deposited when you opened your account.

A simple bet. You win, or you break even, or you lose.

But, you don’t borrow.

2 Likes
3

@Clint
@SimplyOra

with respect… ok

good explanation, but i’d like to add one thing to this point if i may

i believe it would beneficial to clarify to simply ora that
yes… the loss is deducted
HOWEVER… THE MARGIN AMOUNT IS RETURNED TO THE ACCOUNT (assuming Margin call was not achieved and they didn’t blow the account)

outside of that , i agree with every you said.
i just feel that this point would also be helpful to simply ora in my opinion

4

@Clint thank you for your breakdown. It really clears most of the fog.

Leverage allows me to have a position that is beyond my account. With no money borrowed or me having to pay the broker back. (This is how I am understanding all of this).

The broker gives maximum leverage that I am allowed to. The ratio of that will then become the ratio to calculate any trade whereby my position is larger my account and I want leverage. The ratio will determine the margin that I will have to give to the broker to secure my transactions.

If this is how it is, then @Clint you have explained it. Thank you.

I am wondering though whether profit/loss will be, referring to your example above, on the $20 dollars margin or on $2000 leverage?

5

@MartinK, Thank you for the point.

6

[quote=“SimplyOra, post:4, topic:131832, full:true”]
@Clint thank you for your breakdown. It really clears most of the fog.

Leverage allows me to have a position that is beyond my account. With no money borrowed or me having to pay the broker back. (This is how I am understanding all of this). [/quote]

You are understanding it correctly.

[quote=“SimplyOra, post:4, topic:131832, full:true”]

The broker gives maximum leverage that I am allowed to. The ratio of that will then become the ratio to calculate any trade whereby my position is larger my account and I want leverage. The ratio will determine the margin that I will have to give to the broker to secure my transactions.[/quote]

Let me re-word that for you.

The broker places a limit on how much leverage you may use.

In my previous post, I used the example of 100:1 maximum allowable (limit) leverage. That maximum allowable leverage implies a margin amount. That is, if you were to enter a position that was 100 times the balance in your account, then your entire account would be committed to margin, and that margin amount would be 1% of the notional value (size) of your position.

Therefore, 100:1 maximum allowable leverage corresponds to 1% required margin. And this 1% margin percentage applies to every position you take, regardless of the actual leverage you are using.

So, if you have $1,000 in your account, and you take a position worth $1,000 (using 1:1 actual leverage), the required margin will be $10 (1% of $1,000).

If you take a position worth $5,000 (using 5:1 actual leverage), the required margin will be $50 (1% of $5,000).

And if you take a position worth $10,000 (using 10:1 actual leverage), the required margin will be $100 (1% of $10,000).

So, in your paragraph above, you should have said, “The margin percentage (1%) corresponding to the broker’s maximum allowable leverage (100:1), and the notional value (size) of my position will determine the margin amount required to secure this transaction.”

[quote=“SimplyOra, post:4, topic:131832, full:true”]

I am wondering though whether profit/loss will be, referring to your example above, on the $20 dollars margin or on $2000 leverage?[/quote]

Profit or loss is based on the notional value of your position – that is, on the entire $2,000 (leveraged) amount.

That’s the reason for using (actual) leverage – to leverage your anticipated profit.

The downside to using leverage, of course, is that it also leverages your risk. That’s why prudent risk management is the #1 task of any sensible trader. But, that’s a discussion for another thread, at another time.

2 Likes
7

Leverage is something that I take facility from my broker. It is kind of borrowing money from others. It doesn’t mean that my account size is big. Just with a small initial capital started trading business trader takes leverage facility from their broker. That’s why the margin is very important for leverage user. Basically this is what I know about leverage. But I afraid to take leverage facility because it seems very risky to me and I don’t wanted to lose my valuable money.

8

If that’s so, carefully studying and thinking about Clint’s posts above would help you greatly.

1 Like
9

leverage make me crazy in trading…dont use high leverage or your money will depleted…

10

Thank you @Clint you have made me understand a very important part of Forex trading which honestly is invaluable. Once again Thank you.