Margin and Leverage

In a previous video, we noted that you can trade in the Forex market via CFDs by committing only a small fragment of your funds through the use of leverage. Leverage is an investment strategy where the investor borrows capital to invest and if they are successful, they can return the borrowed funds and enjoy the profits. Baby pips defines leverage as having the ability to control a large amount of money using none or very little of your own money and borrowing the rest. So, in retail FX trading, where traders use Contracts For Difference to trade currency pairs via leverage the broker will set aside for example only one thousand USD to allow you to control a position of the size of one hundred thousand USD. That would mean that your leverage is 1:100 as practically you control a position sized at 100k by setting aside only 1000 and that is also called “trading on a margin” with the 1000 USD you commit from your funds being the margin.

So, practically, if for example EUR/USD is trading at 1.1000 and you choose to use 1:10 leverage, then you will only have to put up the 1/10th of the investment (say EUR 10,000) as a margin, meaning EUR 1000 or if you prefer as EUR/USD is trading at 1.1000, USD 1100. So, for an investment of 10,000 Euros, 1:100 leverage would mean that the amount you would have to commit, the margin required would be EUR 100 or USD 110. If leverage is even higher, say 1:500, that would mean that an investment of 10000 Euros would require a margin of EUR 20 or USD 22, which is even lower.

Yet, at this point, we have to highlight that leverage is like a double-edged sword. The advantage is that leverage allows you to make a much higher return as the amount you commit from your own funds is far lower than the actual investment size. On the flip side, the disadvantage is that a small price movement in the opposite direction of your trade can eliminate the whole amount you committed.

Now let’s assume that EUR/USD goes up from 1.1000 to 1.1100. If you close your position, your profit is USD 100. Why? Because it would be the difference between the exchange rate at contract time which is 1.11 and the opening price of the position, which was 1.10, rendering you a movement equal to 0.01 to multiply times the investment size which was 10k. Thus, a profit of 100 USD occurs. If your leverage is 1:1, practically leverage free, instead of 1:100, the profit margin would be a fraction less than 1% because you would have made. But if the leverage is 1:500, your profit margin is around 455%. That’s much higher relative to the amount invested. You have to understand leverage as a magnifying glass. A small movement in your position causes a big movement in your profit/loss statement. Yet, once again, the risk that leverage entails should not be underestimated and the relationship between leverage and risk is linear, meaning that the higher the leverage, the higher the risk. Thus, the decision on the level of leverage to be used should be left to the investor and the investor alone. Only the investor can bear the weight of the decision, as he/she will be taking all the risks.