One of the main features of forex trading is the ability to utilize leverage. But before you get started, it’s important to learn exactly how leverage and margin work, and to understand that increased leverage increases risk.
What is leverage?
Leverage is a tool used by traders that enables them to control a large amount of capital by putting down a much smaller amount. Unlike traditional investing, where you must tie up the full value of your position, with leveraged trading you only have to put up a smaller portion, known as margin.
In the case of 50:1 leverage, for example, you can use $1 to control $50 of a position.
Leverage has opened markets such as forex to more retail traders who don’t want to allocate large amounts of capital to each position. However, it will magnify both the profits and the losses from any trade, so it should be used with caution.
What is margin?
Margin is the collateral that you’ll have to put down to open a leveraged trade. Different forex brokers may have different margin requirements. Typically, the amount of leverage is set forth by the market regulator, such as the NFA, and regulated brokers must adhere to these stipulations.
Margin rates vary among different currency pairs. Let’s examine how different margin rates work in practice.
Leverage example: Unleveraged FX vs Leveraged FX
You want to buy $10,000 worth of USD/CHF. With no margin, you put down a total of $10,000 to open.
The Swiss Franc strengthens against the US Dollar and you sell your position for $10,100—earning you a $100 profit.
You’ve made $100 from $10,000, a profit of 1%.
And if the pair’s price fell to $9,900—you again lose $100, but because you put down $10,000, that equates to a 1% loss.
Forex with a 5% margin
If you want to buy $10,000 worth of USD/CHF with a 5% margin, you only have to use $500 to open.
The Swiss Franc strengthens against the US dollar and you can sell your position for $10,100—earning you a $100 profit.
You’ve made $100 from $500, a profit of 20%.
But what if the Swiss franc weakened instead and you sold your position for $9,900? You’d lose $100, or a 20% loss.
As you can see from the above example, leverage will multiply both your profits and your losses. Because of this, using orders as part of a comprehensive risk management plan is crucial when using leverage.
You’ll always need to ensure that you have enough margin in your account to cover the cost of your open trades. If you don’t, then you could quickly find yourself on a margin call, which means your positions will be liquidated.
If you drop to or below 100% of your margin requirement, your position will be closed automatically.
Returning to our example: let’s say your total account balance is $5,300, USD/CHF drops, and your unrealized loss from the trade is $300. This would mean that you have zero remaining funds with a margin requirement of $5,000. At this point, your position would be automatically closed (liquidated).
This is to prevent your losses from becoming too large.
If you get to 120% of your margin requirement, we’ll let you know via email. At this point, you have three options:
- Close out your position
- Reduce the size of your trade to free up some equity in your account
- Add additional funds to your account to cover the shortfall in margin plus additional funds to sustain any further losses
If you leave your position and it drops to 100% of the margin, we'll close it automatically as per our liquidation policy.
Leverage costs: overnight financing
As with standard investing, you’ll have to pay to open a leveraged trade – via either commission or the spread. When you pay via the spread, the costs of your trade are incorporated into the bid and ask prices. With commission, they are separate.
You’ll also incur borrowing costs on positions that you keep open into the next trading day. This is called overnight financing, also known as the rollover rate, and is applied at market close in New York at 5 PM ET.
Overnight financing is essentially an interest payment to cover the cost of your leverage. At FOREX.com, we calculate it based on the interest rate differential of the two currencies and the spot price, and you can pay or earn the rollover, depending on whether you have a long or short position open.
Calculating rollover rates
A rollover is calculated based on the difference between the two interest rates of the traded currencies. If holding a long position, you will be credited/debited -1 x notional amount x swap points unit quote currency, while short positions will be debited/credited by -1 x notional amount x swap points in unit currency.
For EUR/USD, if swap rates were 0.817/1.28, on a long position of 10,000 you would be charged $1.28 to hold the position overnight. If you were to sell EUR/USD for 10,000, you would receive $0.82 overnight.
Leverage is a tool used by traders that enables them to control a large amount of capital by putting down a much smaller amount