Definition of leverage in Forex

Leverage and margin call are two basic Forex concepts whose definitions may seem unrelated to each other at the beginning. Despite this, the fact is that both terms are closely related so we will explain what they are and and why they should be known by any investor interested in investing in the Forex market.

What is leverage?

Leverage is a tool which allows to trade with large trading volumes using an amount of money (initial capital) much lower. This increases the potential of benefits but at the same time increase the risk of losses. The most usual leverage level provided by most Forex brokers is 1:100 and 1:200.

The explanation that most brokers provide about the financial leverage is generally the following: “is a tool that will help you make money quick and easy”.  In this article we will explain what is almost never mentioned, and it is its other side, ie as the leverage can be disastrous if not known in depth.

On the other hand, it is also true that one of the most important benefits of the Forex market is given by the effect of financial leverage. It is impossible to win in the marketplace without him. This duality is what makes this concept  difficult to understand and what causes the spread of misconceptions about it.

Let’s start with a simple explanation of this concept:

Leverage is a virtual credit form, which allows the investor to trade in the market using the broker´s money. For example, suppose that we have an account with € 1,000.  If we use a 1:100 leverage is like If we had €100,000 (1,000 x 100) in the account. This means that if we open a long position with this capital and the currency pair rises 2% we would earn 2% of 100,000 euros, that means that we would win € 2000 with an initial capital of just € 1,000.  If we suffer losses, in this case the losses would be limited to the initial capital of  €1,000 and never reach the € 100,000.

Financial leverage is defined as the use of external capital per unit of capital invested.

Financial leverage is the only way for small investors to participate in a market that was originally intended only for banks and financial institutions. Leverage is a necessary feature in the Forex market not only because of the magnitude of capital required to participate in it, but also because major currencies fluctuate on average less than 1% a day.

Without leverage, the Forex market would not be as attractive to many investors around the world. Basically, the leverage was designed to allow a greater market share to investors according to their investment capabilities.

Leverage% Required to open a trade$ Required to open a trade with a standard lot$ Required to open a trade with a mini lot
400:1
0.25%
$ 250
$ 25
200:1
0.50%
$ 500
$ 50
100:1
1%
$ 1000
$ 100
50:1
2%
$ 2000
$ 200
25:1
4%
$ 4000
$ 400

The credit or loan of the leverage in the account is guaranteed by the initial deposit. This mechanism prevents the account from falling into a negative balance. So the trader will never lose more money than he put.

Of course, the leverage has its downside, and if not properly used the trader can lose the capital invested in minutes or even seconds. It would be a shame to invest € 1,000 and lose them in seconds.

As many expert traders say, a safe and easy way to make money is to follow the market trend. For example, suppose that the market is bullish (currency rises in value), so we think it is good time to invest € 1,000 with a 1:400 leverage, as it seems a safe business. But although the market is bullish, there are always momentary drops in price after which the upward trend continues. Remember that trends are NEVER  linear.

If our trading account has a relatively small initial capital, we must never use a high level of leverage, because the loss of capital is beyond question. A fall within an uptrend is more than likely and if we use a leverage of 1:400 would mean the loss of all the money. Therefore, it is recommend to use a maximum leverage of 1:100, we should not be greedy and we should also note that the Forex market operates 24 hours a day so the investor can make many transactions.

What is a Margin Call?

To understand this important concept of Forex trading, we must first know what is the margin.

Margin is the amount of money in the account which is needed as collateral to trade in the market. Each broker can set different margin requirements. It is calculated based on the size of the trade and leverage. For example, if we trade with 1 lot and we have a 1:100 leverage our margin required if the base currency is USD is 100.000/100 = $1,000 USD. This means that for each traded lot we require in the trading account a capital of USD1,000.  If the base currency (the first of the currency pair) is not the USD, the broker performs the automatic conversion to that currency.

The free margin is the margin  available in the account for trading. Following the previous example, suppose that we open an account with $2,000 USD. Then we open a 1 lot position which requires a margin of $1,000 USD, so after opening the position we have a free margin of $1,000  USD.

If our losses leave the free margin below the margin required to cover open positions the broker will make a margin call and close all our operations. Because all trades is those moments have significant losses, the broker proceeds to the close of all open positions as a security measure to prevent that the trader end up with a negative balance: This measure is applied for the trader and of course for the broker, as it prevents anyone end up owing money to the broker.

Example: Suppose that we have an account with $10,000 with a leverage of 1:100 and we open a 1 lot position. In this case the used margin is $1,000 and the free margin is $9,000. If losses exceed $ 9000 the broker applies a margin call.

Basically this is the way it works the margin call, however, each broker may have different margin policies and  the trader must be informed about these before opening an account.

Please note: Some brokers increase margin requirements during the weekends. Therefore, if the investor plans to hold open positions over the weekend he should be informed about the policy of the broker. There are brokers with a margin requirement of 30% and even higher.

Concepts such as margin requirements, leverage and risk related to Forex trading should be fully understood by the trader. The trader should know the margin policies of his broker to understand the rules of the game before opening a single trade.