What is Leverage?
Though we have already discussed this subject, it is so crucial that we felt compelled to do so.
The classic definition of “leverage” is the capacity to manage a sizable sum of money with little or no of your own funds and the remainder coming from borrowing.
For instance, your broker will deduct $1,000 from your account to manage a transaction worth $100,000. Your leverage, measured in ratios, is currently 100:1.
With $1,000, you currently have authority over $100,000.
Imagine if your $100,000 investment grows to be worth $101,000 or $1,000.Your return would be a meager 1% ($1,000 gain / $100,000 initial investment) if you had to come up with the remaining $100,000 cash alone.
Another name for this is 1:1 leverage.
Naturally, I believe that the term “1:1 leverage” is misleading because, if you have to pay the total sum you are attempting to control, where is the leverage in that?
Fortunately, your leverage is 100:1 rather than 1:1.
Your return is an awesome 100% ($1,000 gain / $1,000 initial investment), as the broker only had to set aside $1,000 of your funds.
You need to perform a brief exercise right now. Determine your return assuming a $1,000 loss.
A -1% return using 1:1 leverage and a WTF! -100% return using 100:1 leverage would have been the results you would have had if you had computed it the same way we did, which is also known as the correct approach.
You’ve certainly heard the well-worn cliches “Leverage is a two-way street” and “Leverage is a double-edged sword.”
These clichés weren’t lying, as you can see.
What is Margin?
What do you think of the word “margin”? Wonderful query.
Let’s revisit the preceding illustration:
Your broker will deduct $1,000 from your account in order to manage a $100,000 position in the currency market. Your leverage, measured in ratios, is currently 100:1. With $1,000, you currently have authority over $100,000.
You had to provide $1,000 as “margin” in order to employ leverage.
Margin is the sum of money required as a “good faith deposit” with your broker in order to initiate a trade.
Typically, margin is shown as a percentage of the total value of the trade. For instance, the majority of forex brokers state that they need 2%, 1%,.5%, or.25% in margin.
You can determine the maximum leverage you can use with your trading account based on the margin requirements set forth by your broker.
Your leverage is 50:1 if your broker demands a 2% margin.
The other prominent “flavors” of leverage that most brokers provide are as follows:
| MARGIN REQUIREMENT | MAXIMUM LEVERAGE |
|---|---|
| 5.00% | 20:1 |
| 3.00% | 33:1 |
| 2.00% | 50:1 |
| 1.00% | 100:1 |
| 0.50% | 200:1 |
| 0.25% | 400:1 |
Other “margin” words besides “margin requirement” are presumably present in your trading platform.
There is a lot of misunderstanding on what these various “margins” entail, so we will do our best to clarify each term:
Margin requirement: Since we already discussed it, this one is simple. It is the sum of money needed to open a position that your broker requires. It is stated as a percentage.
Account balance: Your trading bankroll is referred to by this phrase. It represents the entire sum of money in your trading account.
Used margin: The sum of money that your broker “locked up” in order to maintain your open positions.
Usable margin: This is the money in your account that is available to open new positions.
Margin call: You get this when the amount of money in your account cannot cover your possible loss. It happens when your equity falls below your used margin.
If a margin call occurs, your broker will ask you to deposit more money in your account. If you don’t, some or all open positions will be closed by the broker at the market price.
