It’s very important that the trader gain a good grasp of these two concepts before engaging in any deals, because leverage and margin determine the lifespan of any trading account in a far more decisive manner than either technical or fundamental analysis.
What is Margin?
Margin trading is trading with borrowed funds, and is closely related to leveraging. The broker allows the trader to control a far greater amount of money in the market in exchange for a small deposit of funds, with the understanding that the sum borrowed must be returned in exact amount, with any losses or profits returned to the account of client (the trader).
A typical margin size might be 1%. So in order for a trader to control 100,000 USD with a margin of 1%, they will need to deposit 1,000 USD. The broker provides the remaining 99%.
What is Leverage?
The amount that the client can control is determined by a number called the leverage ratio.
It’s not that difficult to grasp what the leverage ratio does: it simply multiplies the trader’s potential losses and gains in the market by the specified amount.
For instance if our trader controls 100,000 USD with their 1,000 USD deposit, the leverage ratio is 1/100.
This means our trader will be able to control 100,000 USD (a standard lot), for a deposit of a mere 1,000 USD. Every single pip gain or loss will be multiplied a hundred times.
To put this in a better perspective, you need a movement of just 1% in the price quote before your account is doubled — or wiped out. (Leverage over 50:1 for majors and 20:1 for minors is not available to traders in the U.S.)
In short leverage amplifies your risk, and as such it should be approached with caution, especially at first. Leverage can cause you to both lose and gain massively depending on what you do.
Key Points
- Margin is an amount of money deposited with a broker in order to trade with a larger amount
- For a trader to control 100,000 USD with 1% margin, they will need to deposit 1,000 USD
- Leverage is the ratio that determines how much you can trade with
- To control 100,000 USD with 1,000 USD, the leverage ratio is 1/100
- Leverage amplifies any potential wins and losses so it is very risky
Further Reading
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