Forex Margin and Leverage are two of the most important things a Forex trader must understand, but too often do not. We have attempted to explain how Forex margin and leverage work in simple terminology with examples to help you fully grasp them.
In Forex trading you have the ability to trade forex on margin, meaning we put up a little money and borrow the rest to make a trade. The money you must put up is called your Forex “margin requirement.”
Hypothetically, say you have a $2,000 account. If you want to buy 1 mini lot of USD/CHF (10,000) and your margin requirement is 1% then the broker will set aside $100 (1% * 10,000) of your account balance, while the remaining $1,900 is available to trade with.
The $100 IS NOT your total risk! Your risk is NOT determined by your margin, but rather where you set a stop loss and ultimately exit the trade. If you set a stop loss 25 pips below the entry price, your total risk is about $25 in most forex market conditions, assuming you are filled at the stop price.
Please be aware that a stop loss order is not a guaranteed exit price, but under most circumstances it is the price you will be filled at. If you set no stop loss and the trade continues to go against you by almost 2000 pips, you could ultimately lose the other $1,900 in your account before the broker automatically closes the trade for you to protect against a debit (negative) balance.
Leverage is what you derive from trading Forex on margin. With a 2% margin requirement, you are trading with 50 times (50:1) leverage. With 50:1 leverage, our margin requirement is only 2.0% (2.0% * 50 = 100%).
But please note that leverage is a double-edged sword; it can work for you and against you. Without leverage you would need to put up $10,000 to buy one mini lot with a $1 pip value; most of you wouldn’t bother with Forex at all.
So most Forex traders need some leverage and usually are given more than enough. This means we must demonstrate self-control and not over-leverage ourselves. It is imperative to have a plan to help you trade in a disciplined manner and prevent some of the dangers and pitfalls of Forex margin and leverage.