The forex market is one of the most unique entities of its type anywhere in the world, while it also offers considerable flexibility to traders across the globe.
The main reason for this is the fact that currencies can be traded as derivatives, negating the need for you to assume ownership of the underlying asset. Forex trading is also underpinned by the interconnected concepts of margin and leverage, which impact the size of your positions and potential profitability in the marketplace.
We’ll explore these concepts further below while asking how they relate to one another in the forex market.
Understanding Margin and Leverage
In simple terms, margin refers to the process of making a good faith deposit with your online broker in order to open and manage positions in your choice of currencies.
In fact, it’s the portion of a client’s account balance that’s set aside in order to trade, and you should note that it’s impossible to trade currency without depositing real funds into your account.
Conversely, leverage refers to the use of borrowed funds to increase the size of individual trading positions, which in turn optimizes your trading power and enables you to pursue profits far in excess of your initial deposit amount.
Leverage is typically expressed as a ratio, between your deposit value and the precise amount of money you can trade in real-time. This will be presented in an X:1 format, while the amount of leverage available will vary from one broker to another.
The Relationship Between Margin and Leverage
As we can see, the margin is used to create leverage, and in the case of forex trading, investors can usually control multiple large positions with minimal capital holdings.
To understand this further, let’s say that a broker is offering 50:1 leverage (with a 2% margin required). In this instance, you can control a position worth $50 with just $1 in your trading account, while a deposit of $2,000 would enable you to maintain up to $100,000 across one or more positions.
However, this also highlights the potential downside of leverage, which is often described as “a double-edged” sword that can trigger disproportionate losses in addition to gains.
More specifically, while a margin amount of just 1/50th of the actual trade size is required from an investor to open a particular trade, any subsequent profit or loss would correspond to the total amount leveraged (which would equate to $50 and $2,000 in the examples referenced above).
It’s important to recognize this, as it offers an insight into the true nature of margin, leverage and how they impact your forex trading experience.
It also encourages you to execute informed and conservative trades when starting out, in order to strike the optimal balance between risk and reward in a volatile forex marketplace.
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