Understanding Leverage and Margin

Understanding Leverage & Margin

What is Leverage?

Leverage is the ability to increase purchasing power in the market. Without it, and a trader would need to front $100,000 in order to control 1 mere standard contract in forex. Unfortunately, this may take forex out of many traders' realm of investment possibilities.

Leverage was introduced to help lower the barrier of entry. It allows for a sense of collateral where the trader need only to provide a portion of the contract value, giving the trader 'skin in the game', while the rest of the contract is provided by the broker or bank. Traders with IBFX can trade up to 50:1* leverage, which means the trader would only need to provide $2,000 in order to control the same 1 standard contract (valued at $100,000). Remember, the higher the leverage, the higher the risk. Read our full leverage risk disclaimer here.

Friend or Foe?

Leverage allows for a lower barrier to entry and increased market exposure, but there is such a thing as too much of a good thing. While leverage can be a great tool in gaining access to an otherwise inaccessible market, it can also quickly work against the trader. However, properly employing risk management techniques can go a long way to minimizing the losses caused by the increased leverage.

For example, here is a common error made in the market. A trader will start out with $20,000 (an arbitrary number for example's sake), and purchase 5 contracts. The margin (or collateral) required for these 5 contracts is $10,000, or 50% of the account value. If the trade goes negative a mere 40 points, the account value is losing $2,000 ($10/point), which is 10% of the account value! A couple of small losing trades can quickly wipe out the account.

This is the common error of assuming too much risk.

Manage Your Risk

To help traders manage the added risk that comes with leverage, a general guideline is that traders should risk no more than 5% of account value on any given trade. In the previous example, the trader risked 50% of the account. Fortunately, IBFX offers traders flexible lot sizes, which are very helpful to zeroing in on the risk amount that's right for you. First is the option to trade either standard or mini lot sizes. As mentioned before, a standard lot is $100,000. A mini lot is essentially 10% the size of a standard lot, with 1 contract being valued at $10,000 - thus requiring only $200 in margin.

Traders always have the option of choosing a lower level of leverage. Doing so may help manage risk, but bear in mind that a lower level of leverage will mean that a larger margin deposit will be needed in order to control the same size contracts.

The amount of margin required to place a trade can be calculated using the following formula:

Margin = (Contract size / Leverage)

Traders can also take advantage of fractional lot sizes, which allow a trader to trade less than 1 lot, as low as 0.01 of a lot. A mini contract size of 0.01 would be a contract valued at $100, requiring only $2 in margin. These fractional lot sizes really allow traders to trade almost any contract size!

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Forex Starter Series

Intro to Forex Understanding Forex Pricing Forex vs Stocks Understanding Currency Pairs Understanding Leverage & Margin Intro to Technical Analysis Intro to Fundamental Analysis Learning Your Risk Tolerance

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