What is leverage in forex?
You are probably wondering how a small investor like yourself can trade such large amounts of money.
Think of your broker as a bank that basically fronts you $100,000 to buy currencies.
All the bank asks from you is that you give it $1,000 as a good faith deposit, which it will hold for you but not necessarily keep.
Sounds too good to be true? This is how forex trading using leverage works.
The amount of leverage you use will depend on your broker and what you feel comfortable with.
Typically the broker will require a deposit, also known as “margin“.
Once you have deposited your money, you will then be able to trade. The broker will also specify how much margin is required per position (lot) traded.
For example, if the allowed leverage is 100:1 (or 1% of position required), and you wanted to trade a position worth $100,000, but you only have $5,000 in your account.
No problem as your broker would set aside $1,000 as a deposit and let you “borrow” the rest.
Of course, any losses or gains will be deducted or added to the remaining cash balance in your account.
The minimum security (margin) for each lot will vary from broker to broker.
In the example above, the broker required a 1% margin. This means that for every $100,000 traded, the broker wants $1,000 as a deposit on the position.
Let’s say you want to buy 1 standard lot (100,000) of USD/JPY. If your account is allowed 100:1 leverage, you will have to put up $1,000 as margin.
The $1,000 is NOT a fee, it’s a deposit.
You get it back when you close your trade.
The reason the broker requires the deposit is that while the trade is open, there’s the risk that you could lose money on the position!
Assuming that this USD/JPY trade is the only position you have open in your account, you would have to maintain your account’s equity (absolute value of your trading account) of at least $1,000 at all times in order to be allowed to keep the trade open.
If USD/JPY plummets and your trading losses cause your account equity to fall below $1,000, the broker’s system would automatically close out your trade to prevent further losses.
This is a safety mechanism to prevent your account balance from going negative.
Understanding how margin trading works is so important that we have dedicated a whole section to it later in the School.
It is a must-read if you don’t want to blow up your account!
Moving on for now…
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