What Is Trading Leverage and Margin?
In trading, leverage allows you to control a large position with a smaller amount of money. It’s like borrowing funds to increase your buying power. But you'll need to have a margin account to use leverage.
Margin is the deposit or the amount of money you need to put aside to open a trade. It’s a small percentage of the total trade value that acts as collateral. For example, if you have 100:1 leverage, you only need 1% of the trade's value as margin.
What Is Leverage?
Leverage isn't just a trading term, it's also used in investments, business and in finance in general. In fact, in finance it's one of the important ratios you use for balance sheet analysis.
In trading it's a similar kind of thing, except the leverage ratio on your trading account usually defines what you are able to use as a maximum, rather than what you have already used.
For example, if your account has a leverage ratio of 100:1, it means every $1 you have in your account is actually worth $100. The amount of leverage you have in your account will depend on your broker and you’ll often be able to pick the amount of leverage when setting up your account. Regulations can also dictate the amount of leverage you're allowed. For example, in the UK, retail traders are typically limited to 30:1.
When we trade a currency pair, it's always in amounts of the base currency. For example, a standard lot is 100,000 units of the base currency. One standard lot for EUR/USD would be worth 100,000 euros. Most private traders won't have 100,000 euros to open that trade in the market. Instead, brokers provide you leverage. For example, if the leverage is 100:1, that means you need 1000 euros to open 1 standard lot to trade EUR/USD.
Margin Accounts
Brokerage accounts that have leverage available are called margin accounts. When you open a trade, a certain amount of margin will be put aside for your trade. Margin can basically be thought of as the deposit. If you have a 100:1 leverage account, it means you need to put down 1% of the value of the trade as margin.
For example, let's say your account is $2,000 and you open a standard lot of USD/JPY on a 100:1 leverage account, you have to put aside $1000. This means you only have $1,000 available to you for your trade.
If that trade then moves against you by over 100 points and the loss is over $1,000, your available balance has been eaten up and you're then starting to eat into the margin. It's at this point that you'll get a margin call and potentially have your trade closed.
Just because you have a big limit, it doesn't mean you should use it all. You still need to trade within your means. This means, you should still only ever risk 1 to 2% of your account balance on any trade as a maximum. And when I say account balance, I mean your actual capital, not your total account with leverage.
If you can stick to that, leverage should never become a problem for you, and means you can trade without having to keep all your capital with the broker. If you look at your account and know your leverage, you can work out how much money to keep in your account to cover the margin for your trades.