One of the best things in the forex market is the use of leverage, but it happens that most people do not know what this is or how it operates. But in today’s lesson, we will briefly discuss what leverage in forex is and how it can determine your profits or losses.
What is leverage?
Leverage can be defined as the borrowing of a large sum of money for trading or investing.
Another definition of leverage is having the ability to control a large amount of money with a little capital or investment.
So pertaining to forex, we can use a small account size to control a much larger account size in the forex market.
Who do we borrow this money from?
I believe this is the question that might be running on your mind that who do we borrow this money from the answer is from your broker.
Your broker lends you this money which you will use to trade in the foreign exchange market.
Why do we have to borrow money from our broker?
Remember when we discussed about pips. We said that pips are the fourth or third digit of a currency pair, which is to say that they are the small increment in the price of currencies.
If we are to trade this market with just our own capital, then we are not going to see any reasonable amount of profits or even loss. this is because large amount of currencies need to be bought or sold in other for these little currency increment to make a considerably amount of profit or loss and by the way no body is willing to deposit hundreds of thousands of dollar in their account just to be able to see a significant rise in their profit or loss instead the broker offered to solve this problem for us by offering us a thing of magic called “leverage”.
This is how brokers make trading easier for us, by lending us certain amount of money which can enable us stand a chance in the market.
Where is this borrowed money?
Are you probably wondering where this borrowed money (leverage) is located? When you sign up in your broker’s website there will be an option to choose your leverage usually the default is 1:500 or 1:100 (don’t worry I will explain this later) and let’s assume you decided to use the default leverage (1:500).
With your trading account of $100 dollars that means that in the market you will have a trading capital of $50,000. Pretty cool right!
Let me explain.
For every $1 we have, it will be transformed to $500 when placing an order in the market.
If you don’t understand a thing I just said, don’t worry as I will summarize it all over again in the ending of this article.
Now, to use this leverage your broker will have to set aside a certain percentage of your deposited money called “margin”. (This margin is just a certain portion of your deposited capital)
NOTE that margin is also called GOOD FAITH DEPOSIT – don’t ask me why is called that, I have no clue either.
To make you understand this, I will say that margin is like collateral which your broker will hold in order to open a position for you in the market and when you close this position your capital will be given back to you.
Behind the scene
For your broker be able to grant such huge leverage to you, your margin and that of other trader’s is pooled together – I believe you have understood why your broker can comfortable lend you $50,000 for just a little deposit of $100.
I am not going to bother you with any calculations in this lessons as most people do complained. But if you want to really know more then you will have to embark on a journey to gain knowledge from the far East … kidding just simply Google it.
As I have easier said that “your broker will set aside a certain percentage of your deposited money”. Each broker has a certain percentage which they will keep as a “good faith deposit” it could be 2%, 1% etc. – but this is based on the leverage you choose.
A leverage as high as 1:1000 may have a margin requirement of just 0.03% -depends entirely on your broker.
There are other terms associated with margin such as free margin, margin level. You can see from the mobile mt4 screen shot below.
Let me explain these terms.
Free Margin: This means the total amount of money one can use to open a new trade so technically if I want to open a new trade, another “good faith deposit” will be set aside from that amount.
Margin Level: This shows the percentage before an account hit margin call
Margin: is the good faith deposit
Balance: The totally money I have with my broker excluding the unrealized profits or loss
Equity: This is the aggregate account balance plus the unrealized profit and loss.
What leverage ratio should I use?
This is totally base on you and your trading capital. Institutional Traders usually say that “leverage is a double edge sword” – that is, it can save and also can kill your trading account.
Understand that when using a high leverage, your profits as well as your loss can be huge. Over leveraging accompanied with huge lot size can send your account to the state of “margin call”.
Most traders deposit with less than $100 then use a leverage of 1:1000 while some with larger account size uses 1:100. As I had said it’s based on you and your trading capital.
Hint the more leverage you use, the more positions you would be able to open but if there positions should go against your pre-defined directions it means mass loss which can also suffocate your account.
Generally, I will recommend you use money management
So let me summarize all I just said:
Leverage is borrowed money from a broker and a broker keeps a certain percentage of your trading capital which we call margin or good faith deposit for opening of position in the forex market.
Margins are usually in ratio such as 1:1, 1:50, 1:100, 1:200, 1:500, 1:1000 etc. This means that for every one dollar ($1) you have you can control the following:
$1 in case on 1:1
$50 in case 1:50
$100 in case of 1:100
$200 in case of `1:200
$500 in case of 1:500
$1000 in case of 1:1000
Are you confused? Don’t forget to contact me or comment below