​Online trading accounts offer a very powerful facility called leverage. The term is also referred to as trading on margin, where you can multiply your position by up to 200 times (sometimes up to 500 times). This form of leverage allows traders to not tie as much capital in order to still open larger positions. By controlling a large amount of money and only using a small amount of their own, traders can leverage their positions. 

Trading on a platform giving 200:1 leverage (0.5% used in margin), allows ‘control’ of up to 200 times the money tied up to keep a position open. Let’s take the example from an earlier topic, in order to capitalise on the $5,000 profit, a trader needed to use $100,000 to buy and sell currency with. This 5% return required a very large move in the market of 1,000 pips as no leverage was used. 

If that same trader was using a platform offering 200:1 leverage, they would instead only need $500 ($100,000 / 200) to control the same amount. Platforms are essentially allowing control of a much larger amount as long as the available margin is free in the account ($500). 

Trading platforms will set aside (tie up) $500 as locked funds while that position is open controlling $100,000 worth of currency. Once the trade is closed, that $500 is freed up and once again available in the overall equity to trade with.

 

What is margin?

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This $500 used and stored on the side from the example prior is called the margin. A trader is now able to control $100,000 to trade with, and potentially make a $5,000 profit, by only having $500 available in margin. It is because of these facilities that traders are able to make such large returns on their own capital. 

Contract values and therefore pip movements / margin values when trading on platforms are determined by what the 'quote/term' currency is (i.e. USD ($) in the below EUR/'USD' example).

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• We can see that when a trader is short/long one standard position/contract on the EUR/USD (one lot = 100,000 units of the quote/term currency), they are controlling $100,000 dollars. 

• A trader now only needs available in their account 0.5% (200:1 leverage) of the value in their account to be able to open this trade and control the equivalent of USD$100,000.

• Maximising returns by trading on just one standard position/lot for roughly USD$500 and controlling USD$100,000.

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With the good also comes the bad! Like the upside movement of controlling $100,000 also comes the risk that the market goes the other way. Losses can deteriorate capital very quickly. That is why exercising good risk management and the psychology of trading (later topics) is vital. 

Most platforms will show the cash balance, margin used for open positions, profit/loss and net overall equity available for more trades. If a losing trade is eating away all the capital in your account, a broker will likely request a margin call (request top up your account in order to keep the existing trades open). Otherwise some or all of your positions may be closed out by the platform to prevent losing more than what is in your account. 

 

Cons of leveraged/margin trading

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Outcomes are rarely stress free when it comes to trading on leverage and margin. While the upside when in profit can result in extraordinary returns, being on the losing side of trading with leverage can be dangerous. If it was easy, everyone would be cashing out by trading forex. Sticking with risk management and learning slowly is more likely to decrease the chance of unfavourable situations. 

Let’s take a quick look at how the downsides of trading on margin and having leveraged positions can work:

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If a trader with only $5,000 capital in their account wanted to open contracts far too big for what they have available, they could buy two standard contracts at 200:1 leverage (0.5% margin) on a EUR/USD  (use $1,000 in margin = $100,000 lot size x 2 contracts x 0.005 margin). This position would experience moves of $20 per pip (a pip is the 4th decimal point on a quoted rate such as 1.4329).

If the trader decided to enter the market 1.3200 to go up, and instead it went the other way and in a couple of days days was at 1.3000 (200 pips loss), this would mean their position would be down 200 pips x $20 = $4,000 on a single trade. An 80% loss of capital in one trade. This is why the topic of risk management is so important.

 

Know the impacts and calculate the risk.

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• Traders can experience the dreaded margin calls if they are not using appropriate risk management. This feeling of needing to deposit more money for a losing trade to not be closed out by the broker has put many people in financial hardship and is not a pleasant experience.

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• Higher leverage also affects the cost of the transaction taking place. If a trader was using more leverage this means they are controlling a higher amount of money relative to their account. The way brokers make money is through the bid/ask price spread (and/or often by trading against the trader using an A-book/B-book system).

A trader buying the EUR/USD where the platform offered a 2-pip spread using one mini contract ($10,000 value) is looking at a transaction cost of $2 ($1 per pip value on mini contracts). If the trader decided to use a standard contract ($100,000 value) on the same trade, they are multiplying the position by 10 and it would cost $20 to enter the same trade. 

Leverage can be a beneficial and powerful tool when used wisely!