Sunday, August 28, 2011

What is leverage?

LeverageWe know we've tackled this before, but this topic is so important, we felt the need to discuss it again.

The textbook definition of "leverage" is having the ability to control a large amount of money using none or very little of your own money and borrowing the rest.

For example, to control a $100,000 position, your broker will set aside $1,000 from your account. Your leverage, which is expressed in ratios, is now 100:1.

You're now controlling $100,000 with $1,000. Let's say the $100,000 investment rises in value to $101,000 or $1,000.

If you had to come up with the entire $100,000 capital yourself, your return would be a puny 1% ($1,000 gain / $100,000 initial investment).

This is also called 1:1 leverage. Of course, I think 1:1 leverage is a misnomer because if you have to come up with the entire amount you're trying to control, where is the leverage in that?

Fortunately, you're not leveraged 1:1, you're leveraged 100:1. The broker only had to put aside $1,000 of your money, so your return is a groovy 100% ($1,000 gain / $1,000 initial investment).

Now we want you to do a quick exercise. Calculate what your return would be if you lost $1,000.
If you calculated it the same way we did, which is also called the correct way, you would have ended up with a -1% return using 1:1 leverage and a WTF! -100% return using 100:1 leverage.
You've probably heard the good ol' clichés like "Leverage is a double-edged sword." or "Leverage is a two-way street." As you can see, these clichés weren't lying.

What is margin?

So what about the term "margin"? Excellent question.
Let's go back to the earlier example:

For example, in forex, to control a $100,000 position, your broker will set aside $1,000 from your account. Your leverage, which is expressed in ratios, is now 100:1. You're now controlling $100,000 with $1,000.
The $1,000 deposit is "margin" you had to give in order to use leverage.

Margin is the amount of money needed as a "good faith deposit" to open a position with your broker. It is used by your broker to maintain your position. Your broker basically takes your margin deposit and pools them with everyone else's margin deposits, and uses this one "super margin deposit" to be able to place trades within the interbank network.
Margin is usually expressed as a percentage of the full amount of the position. For example, most forex brokers say they require 2%, 1%, .5% or .25% margin.
Based on the margin required by your broker, you can calculate the maximum leverage you can wield with your trading account.
Time to Get Crunk!

If your broker requires 2% margin, you have a leverage of 50:1. Here are the other popular leverage "flavors" most brokers offer:

Margin RequiredMaximum Leverage

If you want to compare the amount of leverage that different brokers offer, make sure you check out our Forex Brokers Guide!
Aside from "margin required", you will probably see other "margin" terms in your trading platform. There is much confusion about what these different "margins" mean so we will try our best to define each term:

Margin required: This is an easy one because we just talked about it. It is the amount of money your broker requires from you to open a position. It is expressed in percentages.

Account margin: This is just another phrase for your trading bankroll. It's the total amount of money you have in your trading account.

Used margin: The amount of money that your broker has "locked up" to keep your current positions open. While this money is still yours, you can't touch it until your broker gives it back to you either when you close your current positions or when you receive a margin call.

Usable margin: This is the money in your account that is available to open new positions.

Margin call: If your open losing positions drop beyond your usable margin levels, a margin call will occur and some or all open positions will be closed by the broker at the market price.

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