Leverage, Equity and Margin are three concepts which the understanding of is crucial. Leverage is one of the factors that makes Forex trading so attractive and also makes trading of Forex fraught with danger. In most other financial markets you cannot lose more then your initial deposit, however in Forex dependent on your broker you can lose much more then your initial deposit. The Forex market is often referred to as the “Wild West” of the finance industry as there are little regulations and so many rouge operators.
Leverage can be defined in many different ways however we are only interested in the financial definition of leverage. In simple terms leverage in the Forex market allows you to buy a standard lot without requiring you to have $100, 000 of the base currency. You are only required to have a predefined percentage of the full amount in your trading account. The most eloquent definition I have come across is that by the National Futures Association:
“[Leverage is] The ability to control large dollar amounts of a commodity with a comparatively small amount of capital.”
The amount of leverage offered is usually broker dependent and can also depend on the lot size in which you are trading. Generally brokers will offer leverage at rates of either 50:1, 100:1 or 200:1, if however you have a restricted mini account some brokers will offer up to 400:1 leverage.
If we look at 50:1 leverage this means that the initial margin required to trade one lot is $2000. Effectively for every dollar that we invest our broker will loan fifty more. We can see why leverage is so attractive and dangerous, in the equity markets leverage is usually 2:1.
Margin is basically collateral or security that a broker requires you to keep in your account. This collateral allows you to trade leveraged positions.
A simple way to calculate margin is shown below:
Margin = contract size / leverage
Using the previous example of buying one lot at leverage of 50:1:
Margin = 100, 000 / 50
Margin = $2000
In essence when you undertake a leveraged trade the margin is subtracted from your trading account and you are left with what is called usable margin. Your usable margin will fluctuate with price movements. It should be noted that your broker will require a minimum useable margin level. If your usable margin drops below this predefined level your broker will either issue a margin call or liquidate your account, this is of course dependent on your broker agreement. It cannot be stressed enough the importance of knowing your useable margin requirements and margin call policy considering opening an account.
In pure financial terms equity is the difference between an individual or company’s assets and liabilities. In Forex while we have open trades the account equity is simply the margin plus the free or useable margin. Generally equity should always be above margin. When we have no trades in progress Account Balance = Equity = Free Margin.
Trading on a margin can accelerate both profit and loss so it is very important to balance the risk reward of differing amounts of leverage and to choose an amount you are comfortable with.