The Risks and Rewards of Using Leverage and Margin in Trading
Leverage allows traders to execute transactions in an amount significantly exceeding their account balance. With a $100 account and 100:1 leverage, you can open a position worth 100 times your account balance (100 x $100 = $10,000).
Required Margin
The margin determines the amount of collateral needed to open a position. A margin of 1% means that to buy $10,000, collateral of $100 would be required ($10,000 x 1%). The remaining $9,900 will be provided as a loan from the broker.
You can see that the same situation could be presented from a different angle. A 1% required margin equals 100:1 leverage, a 5% margin equals 20:1 leverage, and a 10% margin equals 10:1 leverage.
Margin is not a commission or fee but a temporarily “frozen” amount used to secure the loan. When the position is closed, the margin amount is released.
Example:
We have funded our account with $100 to a broker offering 100:1 leverage. We want to purchase €1,000 at a EUR/USD rate of 1.1500 (the euro is the base currency). Without leverage, we could buy approximately €87 ($100 / 1.15) with our $100. How much leverage would we need to purchase the desired €1,000?
Let’s first convert this amount into our account currency—the USD. €1,000 equals $1,150 at the current exchange rate. This amount is 11.5 times ($1,150 / $100) our account balance. We need a leverage of 11.5 to realize our investment. Fortunately, the selected broker offers a leverage of 100:1, so we can proceed with the transaction’s execution.
At the same time, some collateral will be required from our funds as a margin. The broker’s requirement is 1% of the position size or $1,150 x 1% = $11.5.
Possible Scenarios
Let’s consider two possible scenarios for our long position in EUR/USD. We will profit if the exchange rate increases and lose if it decreases.
- EUR/USD rises to 1.2000: One euro will now be exchanged for $1.20. This means we will get $1,200 for €1,000 when we close our position – a profit of $50 ($1,200 – $1,150). Thanks to this profitable trade, our accounts have increased by 50% to $150. In this case, the leverage has worked in our favor.
- EUR/USD drops to 1.1000: One euro will now be exchanged for $1.10. We will receive $1,100 for our €1,000 when we close our position – a loss of $50 ($1,100 – $1,150). As a result of this losing position, our account has lost 50% of its value, bringing it to $50.
If the exchange rate from the above example goes down to 1.0615 (a loss of $88.5), our broker will make a margin call, automatically closing the position. This action protects the broker from losses exceeding the collateral. The trader’s account balance will be $11.5—the amount initially locked as a margin.
Conclusion
These examples clearly show that leverage can be both a tailwind and a headwind. Leverage terms vary between brokers and countries. Recently, many regulators have introduced more restrictive rules on the degree of borrowing retail traders can use.
