What is Leverage?
Traders do not put in a full amount for trade when controlling a position with a larger amount. They put in some money and rest they borrow from the broker. This is a way to manage the risk of loss. Let’s see how it is done.
Suppose, you want to open a position of $100000, but you don’t want to put in this much money. You broker will then set aside a percentage of this amount which in this case is 1% i.e. $1000 from your account. This makes the ratio of 100:1 (100000/1000) which is your leverage. You are basically controlling a big amount of $100000 with just a small amount of $1000.
Now, let’s say the value has increased to $100900 i.e. an increase of $900. So you are getting a profit of $900 just by putting in $1000!!!
Now, assume if you have to pay full $100000 for this open position. The profit is so small and unsatisfactory. Your leverage would be 1:1. But if we think practically, where is the leverage when we have to pay the full amount? Of course, it’s nil.
But if we calculate other way round, leverage will look like a double edged sword. Suppose the value decrease by $1000 when your leverage is 100:1. Your loss will be 100% as opposed to the leverage of 1:1 when your loss will be just 1%.
What is margin?
A margin is an amount you need to deposit to make a transaction which in the above case is $1000. A margin is calculated in percentage of the full amount needed to open the position. Your leverage also depends on the percentage of margin.
You may come across many different terms related to margin. I am defining here as many terms as possible:
Account Margin – Account margin is the total money you have in your trading account. You have to transfer money from your savings account to trading account before opening any position.
Used Margin – Your broker seals some money to keep the current positions open. These funds cannot be withdrawn until unless you close the current position or get a margin call.
Margin Call – This is the call you get when your losses can’t be covered further with the amount in your trading account. At this point, all the positions are closed by the broker at the current price.
Usable Margin – This is the money available in your account to open a new position.
Now, that you have understood pips, lots, leverage, and margin, let’s move on to our next chapter.