What is leverage?
Leverage is a trading instrument that allows traders to control a significant amount of capital while putting down a much smaller quantity. With 50:1 leverage, for example, you can control $50 of a position with $1. Unlike traditional investing, where you must put up the total value of your position, leveraged trading requires only a smaller part, known as the margin.
It is the ratio between your money and the amount you can trade. For example, if you wanted to trade one lot of USD/JPY without a margin, traders would need $100,00 in their account. But with a 1% Margin Requirement, they must deposit $1,000 in the trading account.
The leverage for this trade would be 100:1.
If the Margin Requirement is 2%, the leverage calculation is:
Leverage = 1/Margin Requirement
1/0.02 = 50
Margin Requirement = 1/Leverage Ratio
1/100 = 0.01
The margin requirement is, therefore, 1%.
Two per cent of a $100,000 position size would be $2,000.
The $2,000 is the margin required to open this specific position.
Since traders can trade a $100,000 position size with just $2,000, their leverage ratio is 50:1.
Leverage = 1 /Margin Requirement
1/0.02 = 50
Leverage has opened markets such as forex to more retail traders who want to allocate only a small amount of capital to each position. However, it will magnify the profits and losses from any trade; therefore, trade carefully.
Open a live account with TIS FX.
What is margin?
Margin is the amount of collateral required to start a leveraged trade. Margin requirements may fluctuate across forex brokers. The market regulator often determines the level of leverage, and registered brokers must follow these rules. Margin rates change across currency pairings.
Say a trader wants to purchase $10,000 in USD/CHF. They lay down the entire $10,000 to open with no margin. If the Swiss franc increases against the US dollar and they sell their trade for $10,100, they will have made a profit of $100. $100 off $10,000, a 1% profit. And if the pair’s price falls to $9,900, they lose $100 again, but because you put down $10,000, you lose 1%.
Forex with a 5% Margin
If a trader wishes to purchase $10,000 worth of USD/CHF with a 5% margin, they need $500 to initiate the position. The Swiss franc increases against the US dollar, allowing them to sell their position for $10,100, giving them a profit of $100. Meaning they made $100 on $500, a 20% profit. But say the Swiss currency fell instead, and they could sell their stake for $9,900. They lose $100, or 20% of their investment.
As seen in the above example, leverage multiplies both profits and losses. As a result, when using leverage, there must be a risk management plan.
Traders must always have adequate margin in their account to cover the cost of their open deals.
If not, the trader might end up with a margin call, which means the trade must be liquidated.
Their trade will instantly be closed if they exceed 100% of their margin requirement.
If an entire account balance is $5,300, the USD/CHF falls, and the unrealised loss from the deal is $300. This means there is no remaining cash on a $5,000 margin need. A Trader’s position would be immediately closed at this moment.
This keeps the trader’s losses from growing too large.
They are then notified through email if they reach 120% of their margin need. There are then three things that happen after.
- Close out your position
- Reduce the size of your trade to free up some equity in your account
- Add additional funds to your account to cover the shortfall in margin plus additional funds to sustain any further losses
Leverage costs: overnight financing
Like traditional investing, you’ll have to pay to open a leveraged transaction through a fee or a spread. They are distinct in terms of commission. The deal charges are integrated into the bid and ask prices when paying using the spread.
Borrowing fees will also apply to positions held open until the next trading day, known as overnight financing, often known as the rollover rate, and it is used at the end of the market in New York at 5 p.m. ET.
Overnight financing is simply a payment of interest to cover the cost of borrowing. It is calculated based on the interest rate differential between the two currencies and the spot price, and traders can pay or earn depending on whether they have a long or short position open.
Calculating rollover rates
The difference between the exchange currencies’ two interest rates is used to compute a rollover. Long positions are credited/debited by -1 x notional amount x swap points in unit currency. In contrast, short positions are debited/credited by -1 x notional amount x swap points in unit currency.
If the EUR/USD exchange rate was 0.817/1.28, a $10,000 long position would be paid $1.28 to hold overnight. If you sell EUR/USD for 10,000, you will receive $0.82 immediately.
You can contact us at the following email address.