Leverage and Margin

The leverage available in forex trading is one of main attractions of this market for many traders. Leveraged trading, or trading on margin, simply means that you are not required to put up the full value of the position.

Forex provides more leverage than stocks or futures. In forex trading, the amount of leverage available can be up to 200 times the value of your account.

There are several reasons for the higher leverage that is offered in the forex market. On a daily basis, the volatility of the major currencies is less than 1%. This is much lower than an active stock, which can easily have a 5-10% move in a single day. With leverage, you can capture higher returns on a smaller market movement. More importantly, leverage allows traders to increase their buying power and utilize less capital to trade. Of course, increasing leverage increases risk.

Margin Trading: Stocks vs Forex

The word "margin" means something very different in forex than it does in stocks.

With stocks, trading on margin means that a trader can borrow up to 50% of a stock's value to buy that stock. This can be a costly move because the investor must pay interest to the brokerage firm on the amount borrowed. This is not the case in forex trading.

* For example, at $400/share, 100 shares of Google are valued at $40,000 ($400 x 100 shares). To trade this stock on margin, the money required for the trade is 50%, or $20,000. The remaining $20,000 is borrowed and interest must be paid on that amount. Margin interest is different from broker to broker, but a good rule of thumb is typically Prime plus 1-3% or more.

In forex, margin is the minimum required balance to place a trade. When you open a forex trading account, the money you deposit acts as collateral for your trades. This deposit, called margin, is typically 1% of the value of the position.

* For example, if you want to purchase $100,000 of USD/JPY at 100:1 leverage, the money required is 1%, or $1000. The other $99,000 is collateralized with your remaining account balance. You pay no interest.

It is very important to remember that increasing leverage increases risk. You should monitor your account balance on a regular basis and utilize stop-loss orders on every open position in an attempt to limit downside risk.

Here's a hypothetical example that demonstrates the upside of leverage:

With a US$5,000 balance in your account, you decide that the US Dollar (USD) is undervalued against the Swiss Franc (CHF).

To execute this strategy, you must buy Dollars (simultaneously selling Francs), and then wait for the exchange rate to rise.

The current bid/ask price for USD/CHF is 1.2322/1.2327 (meaning you can buy $1 US for 1.2327 Swiss Francs or sell $1 US for 1.2322 francs)

Your available leverage is 100:1 or 1%. You execute the trade, buying a one lot: buying 100,000 US dollars and selling 123,270 Swiss Francs. At 100:1 leverage, your initial margin deposit for this trade is $1,000.

As you expected, USD/CHF rises 50 pips to 1.2372/77. Since you're long dollars (and are short francs), you must now sell dollars and buy back the francs to realize any profit.

You close out the position, selling one lot (selling 100,000 US dollars and receiving 123,720 CHF) Since you originally sold (paid) 123,270 CHF, your profit is 450 CHF.

To calculate your P&L in terms of US dollars, simply divide 450 by the current USD/CHF rate of 1.2372. Your profit on this trade is $364.3

SUMMARY
Initial Investment: $1000
Profit: $364.31
Return on investment: 36%

If you had executed this trade without using leverage, your return on investment would be less than 1%.

This information was provided by Forex,44 Wall Street, 7th Floor, New York 10005.