Forex Trading: Leverage
When entering trades in the market, in addition to knowing the different ways we’re going to participate in it, we must also keep in mind the number of lots we are going to trade, and consequently, the risk that we are going to expose ourself to in each trade.
When deciding the number of lots with which we will trade, we have to know key concepts such as leverage and margin.
What is leverage?
Leverage is nothing more than the ability to trade with much larger amounts than we actually have in our trading account. The person in charge of supplying us that financing of our trades is none other than the broker himself.
For example, we know that in the case of buying a lot of the EUR/USD pair we are actually buying $100,000. It is possible that in our case we do not have that amount in our account, not even close. But thanks to the leverage provided by our broker it is not necessary to have in the $100,000 account to buy a lot of the EUR/USD.
If, for example, our broker gives us a 200: 1 leverage, a regular Forex figure, we can take a trade with 1 lot of Forex simply by having in our account $500, 200 times less than what we are actually moving in the market. Hence the enormous, and at the same time dangerous, power of the leverage, since while it is true that we are multiplying our profits by 200, we are also risking enormous losses in case the market is not in our favor.
The margin consists precisely in the economic guarantee that the broker retains to allow us to trade in the market with leverage. In the example above, those $500 required to trade a EUR/USD lot is the margin that the broker will hold whenever the transaction is active.
The margin is not a commission or a charge, it simply retains that amount from our account so that we can not expose it to a new transaction, thereby increasing the risk.
The remaining amount that is available in the account is what is known as free margin, which will serve us either to continue opening trades whenever the amount is sufficient or to absorb the possible floating loss that are generated from our open trade.
It is important to note the concept of floating loss, although it is true that the loss of a trade is not actually executed until it is closed, in the event that it is negative, these losses are subtracted from our free margin. If it reaches 0, the broker will automatically close the trade (since we have no more guarantees than the initial) and will be subject to what is known as margin call.
That is why it is very important not to use the entire account to open trades, since to do so, the chances of closing down trades with losses stemming from even the slightest movement against us are increased considerably. Happy Trading.