Leverage, margin and risk are three terms that may be used interchangeably amid trader circles, but in reality there is a very clear distinction between the three:
When you buy a house, you often have to put a down payment and borrow the rest. The amount that you have borrowed is called leverage. The same applies to trading. If you wish to trade with a larger amount than that which you own, you set your leverage accordingly. The broker will typically offer different ratios of leverage raging from 1:50 to 1:200. It is important to remember that the higher the leverage the higher your losses or profits will be. When using leverage, it is therefore important to understand that you are essentially increasing your risk. To keep you from opting from a higher leverage than what you can handle as a trader, brokers like BDSwiss will administer an appropriateness test. If you lack the knowledge to use leverage appropriately, then you will be limited to a lower leverage ratio. But let’s get back to how leverage works…
In a currency transaction, if the leverage 1:50, then for every one euro of your own money, you are borrowing another 49 euros. Essentially each one of your euros is multiplied by 50. So, if you open a position of €1000, using a 1:50 leverage you need to have at least €20 in your account balance. You are putting your €20 and borrowing another $980.
Whilst leverage is the amount borrowed, margin is the amount put in – your money. Margin is the amount you are contributing to a certain trade and in essence it is also the amount you stand to lose should the markets move against you. Going back to our previous example, that €20 you have invested, refers only to the “initial margin”. Margin is also the term used for the amount of money that you need to keep in your account to sustain a position, called the maintenance margin. This means that if you incur a loss greater than €20 you may still keep your position open but you will essentially be risking the rest of your available margin, in other words, your account balance, should the markets continue to move against you.
Eventually, if your position threatens to wipe your account clean, there will be a point where the position will be automatically closed, this is called a margin call, and this varies between brokers. Once you get a margin call and if you still would like to sustain your position open, the automatic closing of your position could be prevented by depositing more funds. If you are using MT4, the amount that you are still able to trade is often called “usable margin”, whilst the amount of your equity that is being used is often termed “used margin”.
Risk refers to the amount of money that you are risking. But as we have already explained, risk in forex trading is impacted by the amount of leverage and margin. In forex, high leverage can multiply any profits but it can also put your entire balance at stake. Risk management on the part of the trader is therefore very important and as a trader you need to ensure that you are familiar with the risks involved in trading leveraged products such as Forex and CFDs.