Leverage and Margin
When you talk about leverage, think about a loan. Who gives away this kind of loan? FOREX broker who takes care of the trader’s account provides the loan. Possible options of leverage are 50:1, 100:1 or 200:1 depending on a broker and the size of the position you are trading.
Standard lot size is USD $100,000 so for a trade of this size the leverage is usually 50:1 or 100:1.
For a trade smaller then $50,000 (mini lot size -USD $10,000) the leverage is usually 200:1.
Sounds a bit crazy, but that’s the way the cookie crumbles! That being said, lets see yet another example:
For your deposit of, let’s say, $1,000 you can trade 1 lot of $100,000. And with $7,000 you will trade up to $700,000. In this example the broker asks a 1% margin (minimum security) for each lot – for every $100,000 traded, the broker wants a deposit of $1,000. First, let’s look at the example of trading without margin.
SCENE 1: You have opened an account of $1,000 with 100:1 leverage. So basically you have the purchase power of $100,000. And you see that USD/JPY exchange rate at 109.3.
In case you decide to trade without margin, you only have $1,000 of buying power. With $1000 the maximum amount of Yen you can buy is 109,300 Yen. Not sure how we came up with this number? Here is the explanation:
USD/JPY exchange rate at 109.3
Base currency = USD. The base currency always has a value of 1. This means that for 1 USD you can buy 109.3 JPY. This also leads to the conclusion that for 1,000 USD you can buy 1,000 x 109.3 = 109,300 JPY.
SCENE 2: Later on you see that USD/JPY exchange rate at 109.0. It is time to see off your Japanese Yen and get some profit! How much dollars can you get for 109,300 JPY at the current exchange rate? Let’s calculate:
109,300 / 109.0 = USD 1002.75
CONCLUSION: So, initially you had USD $1,000 and now you have got USD $1002.75. Your profit is
1002.75 -1,000 = $2.75
Now let’s consider the same example but trading with margin
SCENE 1: With margin, your account of $1,000 has a power of $100,000. You buy Japanese Yen while USD/JPY exchange rate at 109.3. How much Yen did you get for $100,000?
100,000 x 109.3 = JPY 10,930,000
SCENE 2: Now USD/JPY exchange rate at 109.0 and you want to buy USD back. How much can you get?
10,930,000 / 109.0 =100,275
CONCLUSION: The profit you have made in this trade is 100,275 – 100,000 = USD $275.
The given examples are of course much simpler then the real marketing situation, but it illustrates the main trading idea in a comprehensive way.
Leverage can be represented as a ratio or in terms of margin percentage. In order to understand both representations, remember this:
Leverage = 100 divided by Margin Percent
Margin Percent = 100 divided by Leverage
We are already seen examples of leverage represented by a ratio – 50:1, 100:1, or 200:1.