Leverage and Margin in Forex and CFD Trading – Complete Guide

Trading in the forex and CFD markets offers immense profit opportunities, but it also comes with its own set of complexities and risks. Among the critical concepts that traders must grasp are leverage and margin.

Leverage and margin can amplify your trading potential, but also magnify your losses if not used wisely. In this guide, we explain leverage and margin, focusing on how they work and the benefits and risks they involve.

Understanding Leverage

What is Leverage?

Leverage is a powerful tool in forex and CFD trading that allows traders to control a larger position size with a relatively small amount of capital. Essentially, leverage means borrowing funds from your broker to increase your trading exposure.

How Leverage Works

Leverage is expressed as a ratio, such as 1:10, 1:50, or 1:100. This ratio indicates how much more exposure you have compared to your actual investment. For instance, with a 1:100 leverage, you can control a position worth $10,000 with just $100 of your own capital.

By using leverage, you can potentially increase your profits because even a small movement in the market can lead to significant returns relative to your initial investment. However, the same is true for losses, which can also be magnified.

Example: If you deposit $1,000 into your trading account and your broker offers 1:50 leverage, you can trade positions up to $50,000. This means that with a relatively small amount of capital, you can take larger positions in the market.

Why Brokers Offer Leverage

Leverage determines how much funding you can borrow from your broker to trade. This begs the question: Why would your broker need to lend you funds in the first place? Essentially, brokers want you to trade higher volumes because they can then charge you higher spreads and commissions. The more you trade and the more successful you become, the more your broker stands to gain from you as a client.

Discover our list of Best forex brokers with high leverage.

Understanding Margin

What is Margin?

Margin is the amount of money required to open and maintain a leveraged position. It acts as a security deposit, ensuring you can cover potential losses.

How Margin Works

To understand margin better, let’s explore its components and their interrelations.

The margin requirement is a critical concept related to margin. It represents the percentage of the total trade value that you need to deposit to open a position. For instance, if you wish to trade $10,000 worth of currency with a 5% margin requirement, you need to deposit $500. This requirement ensures that you have sufficient funds to cover potential losses while also allowing you to control a larger position with a smaller initial investment.

Once you have opened a position, the concept of used margin and free margin becomes relevant.

• Used margin is the amount of money that is currently being used to maintain open positions.
• In contrast, the free margin is the remaining amount in your account that is available for opening new positions. It is calculated as the difference between your equity (total account balance including unrealized profits or losses) and the used margin. For example, if your account equity is $2,000 and your used margin is $500, your free margin would be $1,500.

Another important measure is a margin level that reflects your trading account’s health. It is calculated by dividing your equity by the used margin and then multiplying by 100, resulting in a percentage. This percentage helps determine whether you can open new positions or need to close existing ones. Brokers typically set a minimum margin level threshold below which you may receive a margin call.

A margin call occurs when your margin level falls below the broker’s required threshold. This means you must deposit more funds to maintain your open positions or close some positions to free up your margin. If you fail to take action, the broker may automatically close your positions to bring your margin level back to the required amount.

Margin Rates

In the table below, you can see how the total available margin changes with different leverage rates:

Leverage and Margin in Action

To understand how leverage and margin work, consider the following example. You want to trade 1 lot (100,000 units) in EURUSD, with a current spot price of 1.0650. Accordingly, the value of trade would be $106,500 (100,000 x 1.0650).

Here is how much your margin requirement would be at different leverage rates vs how much your broker would be lending you to open such a trade:

This table shows that even relatively low leverage could have a massive impact on your margin requirement. Hence, even small changes in the underlying price could have a significant impact on your profit/loss performance. To better appreciate the underlying risk, it is important to understand what a pip value is.

Pip Value of a Trade

As the name suggests, a pip value refers to the profit or loss generated when the price of the underlying moves by a single pip. To calculate a Forex trade’s pip value, you can use the formula:

Accordingly, the pip value of a full-sized EURUSD trade is $10 (0.0001 x 100,000 units). So, in the example from above, if you’ve used a $1065 initial margin to execute a full-sized EURUSD trade with a 1:100 leverage, it would take less than 107 pips for you to lose your initial margin (if your trade goes horribly wrong). That is why it is so important to understand just how far the market could go against you before you have to cut your losses short.

Real Market Example

To understand how the market changes over time, consider the following example, where the performance of the underlying trade fluctuates over several days.

Your account balance is $10,000, and your leverage is 1:100. You wish to open a long (buy) full-sized EURUSD trade at 1.0650. The pip value is $10. This is how your portfolio would change depending on how the market moves:

Leverage and Margin Managing Strategies

How to Choose an Appropriate Leverage

There is no exact formula for defining the right leverage rate for your trading profile. However, you can assess the risk associated with your preferred leverage by considering a few key factors.

• Start Small: If you have a $1,000 account and choose a leverage of 1:10, you can control a position size of $10,000. However, if you’re a beginner, you might start with 1:5 leverage, controlling $5,000, to manage risk better.
• Use Risk Management: With the 1:10 leverage, risking 2% of your account means you risk $20 per trade. Ensure your stop-loss and position size align with this risk level.
• Understand Your Comfort Level: Determine how much risk you are willing to take on each trade. This depends on your financial situation and personal risk appetite. A common rule is not to risk more than 1-2% of your account balance on a single trade.
• Evaluate Your Trading Experience: To minimize risk, it is better to start with lower leverage and use demo accounts to practice trading with different leverage levels before committing real money.
• Consider Your Trading Strategy: Short-term traders (e.g., day traders) might use higher leverage since they typically hold positions for shorter periods. Long-term traders should use lower leverage to reduce risk over longer holding periods.
• Consider Account Balance: Ensure your leverage choice aligns with your account size. Smaller accounts should use lower leverage to avoid large percentage losses.
• Examine Position Size: Calculate your position size based on leverage and margin requirements to ensure it fits within your risk parameters.
• Review Regulations: Be aware of regulatory limits on leverage in your region, as they can affect your available options.

Choose the best-fit broker from our list of Best regulated forex brokers.

How to Monitor and Manage Your Market Exposure

The higher leverage you use, the higher market exposure you will have with each trade. This means that you must monitor how your free and used margins fluctuate over time. If you receive a margin call from your broker, you should deposit additional funds into your account or close out your losing positions.

If you have more than one open trade with a running loss and you receive a margin call, unless you deposit additional funds, it is best to start cutting your losses with the position that has accumulated the largest running loss. This is because it has the smallest chance of turning around and is more likely to continue going against you.

Regulatory Considerations

Leverage Restrictions

The maximum leverage you can use may vary depending on the jurisdiction where your broker is regulated. For example, in strictly regulated jurisdictions, such as Europe and the US, the maximum retail leverage is set at 1:30. In contrast, offshore brokers may allow proportionally higher maximum leverage.

In the table below, you can see how the maximum leverage varies from one jurisdiction to another:

Broker Margin Policies

Brokers typically allow different maximum leverage rates on instruments across different asset classes. For example, European brokers usually afford a maximum retail leverage of 1:30 on currency pairs and 1:5 on share CFDs.

The easiest way to check these discrepancies is on the broker’s website. Almost all broker websites have a ‘Contract Specifications’ page, where you can check the margin policy, maximum leverage, maximum volume, and more. For more detailed information, you can go to the ‘Legal Documents’ section of the website and check the broker’s Key Information Documents (KID). There, you will find more comprehensive information for each available asset class.

Conclusion

In margin trading, the broker lends the trader funds, which can be used to trade higher volumes and thereby achieve more significant results. The leverage multiplies the profits generated from winning trades and losses incurred from losing trades. That is why traders must understand the underlying risk associated with margin trading before proceeding to trade leveraged products.