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What are Leverage and Margin Requirements?

FX Scouts By Jeffrey Cammack Updated: August 27, 2019

Leverage is the concept of borrowing money to increase the volume of a CFD trade and thus significantly increase the potential profit. Leverage is a double-edged sword, however.  On the one hand, it helps trade larger volumes and grows our account balance quicker, but on the other hand, it can also amplify your losses, and you can lose significant amounts of capital on a few bad trades.

An Example of Leverage

Assume that you have an account balance of $10,000 and your broker offers you the standard 1:100 leverage. A leverage of 1:100 means that you can control $1,000,000 worth of buying power ($10,000 x 100) with only $10,000. In this example, you decide to only buy $100,000 worth of EUR/USD at a rate of 1.1800. Since our position size is only $100,000, or 10 times more than our account balance, we are ultimately just using effective leverage of 1:10. After we bought EUR/USD, the exchange rate moves up to 1.2000, and you decide to close your trade, making a 200 pips profit.

The total profit is $2000 (200 pips x $10/pip).

If you have not used leverage, and only used your $10,000 to buy a small EUR/USD position, your total profit after EUR/USD had rallied 200 pips would have only been $200. Your 1:100 leverage has allowed you to earn ten times more than you would have if you were trading without leverage. Depending on your account type and your risk profile, you can trade smaller or bigger position sizes and use a different level of leverage. If you want to understand how to size your trades correctly, you should be familiar with the concept of Margin Trading. Leverage and margin are intrinsically tied together.

What is Margin Trading?

In Forex trading, if you’re using leverage, you’re not required to own the entire position size of what you’re buying and selling. You only have to deposit enough money to cover possible losses.  This deposit is called the Margin. The margin is the amount of money that your Forex broker will require you to put up to open a trade.  The broker will lock up the required margin for the period the trade is held, and it will release it back to you once the trade is closed. For example, if you want to buy 10,000 EUR/USD, you either deposit the whole amount, but with margin trading if you choose leverage of 1:100 you only have to put up 1/100 of the total amount as margin – which will be $100. So with $100 margin, you can trade $10,000.

Conclusion

To earn money from the Forex market trade sizes need to be larger than most retail trader’s account balance.  Leverage is the mechanism in Forex trading that helps trader borrow money against their account to inflate the size of the trade. Leverage can turn good trades into great trades, but while leverage can boost your potential profits, it can also lead you to more significant losses. The key to using leverage correctly is to employ sound risk management strategies and improve research trades before opening the position.

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Trading Forex and CFDs is not suitable for all investors and comes with a high risk of losing money rapidly due to leverage. 75-90% of retail investors lose money trading these products. You should consider whether you understand how CFDs work and whether you can afford to take the high risk of losing your money.