Margin and Leverage – Everything A Beginner needs to Know!
For novice traders, understanding the concept of margin and leverage can be a bit difficult. Here, we take you through what leverage is, its advantages and disadvantages, and should you consider using it in your trading strategies as a beginner.
What is Leverage?
Fundamentally, leverage is a loan. However, it is a loan that is given with an explicit purpose: to trade. Traders can use borrowed money to trade larger positions than they would otherwise be able to.
While leverage is prevalent in most asset classes, it is most common in forex trading. Since currencies change at a very slow pace, leverage allows traders to earn better returns than they would otherwise be able to (albeit with a higher risk).
Forex brokers allow their clients different amounts of leverage depending on the asset traded and the type of account. In forex, it is common to see leverage ratios of 100:1. This means that for every $1 capital that the trader has, they can use $100 to trade. The additional amount that they get to trade with is known as leverage.
What is Margin?
Margin and leverage are inherently related. Margin is the initial amount required to place a trade. For example, if the leverage ratio is 100:1 (as in the example above), the initial margin required to trade $200,000 would be $2,000 (200,000/100).
When it comes to standard forex contracts, they require 100,000 units of currency. The most common leverage ratios offered by brokers are 50:1 and 100:1. However, it is possible to find brokerages that offer higher leverages, especially for clients that have larger trading volumes.
Remember that when you are trading on margin, you need to maintain a margin requirement. This is the minimum amount of balance you must have in your account to make sure that you can use leverage in your trades. If your balance falls below this amount, your positions will be closed. This is known as a margin closeout, sometimes also called ,margin stop-out.
Advantages and Disadvantages of Leverage
At its core, leverage only has a singular effect on your trades, and that is both its primary advantage and disadvantage. Leverage magnifies both the profits and the losses experienced on your trades. As such, it can lead to higher profits, but it can also lead to higher losses.
This is basically what leverage is for beginners. At the advanced level, it has other benefits such as allowing traders to manage risk and combat low volatility. However, even professional traders often experience gigantic losses due to leverage, and many renowned financial institutions have gone bankrupt because they experienced losses on heavily leveraged trades.
Should Beginners Use Leverage?
When it comes to most other assets such as stocks, conventional wisdom dictates that beginner traders should not use leverage. However, trading forex without leverage is almost impossible, as the profits are made on the tiniest of currency movements.
Most brokers will offer leverage beginning from 30:1. This is what we would recommend for most people who are just starting out in forex trading. This is to make sure that you do not end up losing a lot of money from beginner mistakes. Eventually, you will want to switch to 100:1, which is the standard leverage used by most traders (even most of the advanced ones).