Do you ever get confused between leverage and margin or margin and risk? Do they seem to be used interchangeably or for more than one thing?
If you are confused, below is a quick explanation of what they mean and how they are used in currency trading.
When you buy a house, you often have to put a down payment and borrow the rest. The amount that you have borrowed is called leverage.
Let’s give an example. If the house you want to buy costs $100, and you only have $10 dollars, you have to borrow $90 dollars to buy that house. The leverage on the house is $90.
Out of the $100, you have contributed $10. To put this into a ratio, it is 100:10, which as us math lovers know, is the same as 10:1. Leverage is often put in ratios like the one above when trading currencies.
So in a currency transaction, if the leverage offered is 25:1, then for every dollar of your money in the transaction, you are borrowing 24 dollars. If you want to open a position worth $1000, at a 25:1 leverage you are putting in $40 and borrowing $960.
Whilst leverage is the amount borrowed, margin is the amount put in, your money. To use the house example above, the margin describes your contributed $10.
But that $10 you put in refers only to the “initial margin”. Margin is also the term used for the amount of money that you need to keep in your account to sustain a position, called the maintenance margin. This is necessary because the lender needs to make sure that you can pay it back if the value of the investment drops.
With the house, if it loses all its value, ultimately the bank loses $90, whilst you lose $10. So, as part of the risk management, the bank insists that you make available to them funds in case the house loses value. As the house decreases in value, the bank begins to take money from the funds you set aside, until a cut-off point whereby the house is sold to prevent further loss.
The same thing happens in currency trading. Leverage exposes a trader to the possibility that a decrease in value will exceed the initial amount that the trader put into the position. Going back to our currency example above, if the $1000 position lost $50, you have lost your initial $40, but the lender has also lost $10 as well. Your equity must now be used as the maintenance margin and the $10 is taken from it into the position, to ensure that the lender suffers no loss. Eventually, if your position threatens to wipe your account clean, there will be a point where the position will be automatically closed, called the margin call, and this varies between brokers. This can be prevented by putting in further funds.
If you are using MT4, the amount that you are still able to trade is often called “usable margin”, whilst the amount of your equity that is being used is often termed “used margin”.
This one is simpler to understand. Risk is the amount of money that you or the lender is risking.
But risk in forex trading is impacted by the amount of leverage and margin. In the house example, you are risking $10 and the bank is risking $90. But, in reality, the bank is not risking its $90 as your drawable equity covers their losses until they compel you to sell to ensure that they do not lose their money.
The degree of leverage also impacts your risk, the more leverage, the more you stand to lose. For example, if you only have $1 invested in the $100 house, you can lose $100 of your investment with a drop in value from $100 to $99. But if you put in $50 because the bank will only lend your $50, then a drop of $1 will cause little impact on your equity.
In forex, the high leverage can create a scenario similar to the $1 margin for a $100 property. Often a trader has a position on a high leverage that may not be a large position, but it can still threaten the entire balance because it is losing a lot of money. Risk management on the part of the trader is very important to ensure that a losing position is closed before it wipes off too much equity.Get the 5 most predictable currency pairs