Summary
- Leverage is the use of borrowed funds to increase one's trading position.
- Traders are can choose from a range of leverage ratios offered by the broker.
- Leverage is a double-edged sword; it can amplify your profits, likewise your losses.
We've discussed this previously. Leverage allow traders to use a smaller capital to trade larger amounts of money by utilizing margin.
What exactly is Leverage and Margin?
The textbook definition of Leverage; it refers to the the ability to control a large amount of money by the use of a significantly smaller trading capital (security deposit also known as margin) and borrowing the rest.
For example, to control a $100,000 trade position, the broker will set aside $1,000 from your account as margin. This also means, you're controlling a trade position of $100,000 with $1,000. This is commonly expressed in ratios, in this case; 1:100 and the margin required is 1%.
Leverage 1:100
In most cases, brokers will offer a range of leverage ratios that start from 1:1 to 1:200 and in some cases even going up to 1:500. The table below will show how leverage and margin goes hand-in-hand;
Margin Required | Leverage |
|---|---|
5% | 1:20 |
2% | 1:50 |
1% | 1:100 |
0.5% | 1:200 |
0.2% | 1:500 |
Margin required based on Leverage
Here's a scenario of how the different leverage and margin works.
Scenario 1: Leverage 1:100
If the trader wants take on a trade position of $100,000, the broker requires a margin of 1%, that would be $1,000.
Scenario 2: Leverage 1:50
If the trader wants take on a trade position of $100,000, the broker requires a margin of 2%, that is $2,000
Scenario 3: Leverage 1:200
If the trader wants take on a trade position of $100,000, the broker requires a margin of 0.5%, that would be $500.
How does that affect me?
- Let's say the price for EUR/USD is 1.26837 and the trader decides to trade 1 Lot, which means the trader decides to take on a long position(buy trade) worth 1.268837 x 100,000 = $126,837
If the trader opts for the leverage of 1:200 that is offered by the broker, the margin required will be $126,837 x 0.5% = $634.19.
EUR/USD 1.26837
| Leverage 1:1 (No Leverage) | Leverage 1:200 |
|---|---|---|
Trade Amount / Volume | 1 Lot (100,000) | 1 Lot (100,000) |
Amount of margin required | 126,837 USD | 634.19 USD |
Notice how the amount of margin required differs. Now lets say the price of EUR/USD went up 3pips, from 1.26837 to 1.26867, this will amount in the following profits:
EUR/USD 1.26837 ➜1.26807
| Leverage 1:1 (No Leverage) | Leverage 1:200 |
|---|---|---|
Trade Amount / Volume | 1 Lot (100,000) | 1 Lot (100,000) |
Amount of margin required | 126,837 USD | 634.19 USD |
Profits | 126,867-126,837 = 130USD | 126,867-126,837 = 130USD |
Likewise if the price falls by 3pips, from 1.26837 to 1.26807.
EUR/USD 1.26837 ➜1.26807
| Leverage 1:1 (No Leverage) | Leverage 1:200 |
|---|---|---|
Trade Amount / Volume | 1 Lot (100,000) | 1 Lot (100,000) |
Amount of margin required | 126,837 USD | 634.19 USD |
Losses | 126,807-126,837 = -130USD | 126,807-126,837 = -130USD |
There's a common analogy in the financial world that, Leverage is a doubled-edged sword. Even if the profit/loss dollar value is the same, the percentage gain based on capital requirement is vastly different.
Based on examples above, with a price movement of 3pips;
If a trader doesn't uses leverage (1:1), the profit/loss in terms of percentage is 130 ÷ 126,837 = 0.1%.
But if the trader opts for leverage ratio 1:200, the traders profit/loss in terms of percentage will be 130 ÷ 634.19 = 20%.
