1.20 Margins and Leverages in Forex Trading
Forex leverage trading or Forex margin trading is the facility to be able to trade for significantly higher amounts than what you have in your account. We can define Leverage as the extent of the open positions you are allowed to create in the market against a given amount of margin deposit. You may also like to check on margin calculation.
If the broker is allowing you ‘leverage’ of say 50:1, then it means that you only have to put up an initial margin of 2% of the value of the position you want to trade. Assuming your account currency is USD and the value of the position was $50,000 then the broker would earmark 2% of $50,000 i.e. $1,000 from your account towards the margin deposit.
In effect, the broker funded your position for $49,000 - the amount of capital you may be said to have ‘borrowed’ for the position.
(Take note that the ‘leverage’ afforded by the broker here is different from the ‘true leverage’ of your account, a measure of its overall risk, but that’s for later!)
Because of the leverages offered, Margin trading is a facility offered by a Forex broker to his clients so that they may trade without having to put up the entire capital required for their position. The client is therefore trading with borrowed capital. However, the broker will always demand a certain, small deposit of money, called the margin deposit to be paid by the client before the position can be taken. In fact, this deposit, which may be as low as 1-2% of the value of the total position, is the only initial investment required of the client.
The broker earmarks this amount and sets it aside against the position taken by the client. When the position is squared up by the client, at a profit or loss, the margin is released back, along with the credit for the profit or loss on the transaction.
Profits and losses with leveraged trading
Leverage is a double edged sword - while your profits would be multiplied by the same amount, say 50 times in the above example, same would be true for your losses if your trade goes to south. It is always better to play safer by using optimum levels of leverage and not too high.
How Leverage or Margin trading works?
A couple of logical questions are that how you can take so large positions for such petty amounts and why the broker is lending you that balance amount so easily. What’s there in it for the broker?
Margin Trading Scenario and Example
Let’s assume the following:
- You have a Forex account with USD 10,000. Your account currency is U.S. dollars.
- You are trading with a leverage of 50:1 i.e. you can take up positions worth USD 50*10,000 i.e. USD 500,000.
- Your broker offers a spread of 1 Pip.
- You are trading with EUR/USD and the current exchange rate is 1 EUR = 1.1400 USD i.e. EUR/USD = 1.1400.
Now if you take a position to buy 1 standard lot i.e. 100,000 euro, you need to sell 1.1400*100,000 U.S. dollars i.e. 114,000 USD. As the leverage is 50:1, you need a margin money of USD (114,000/50) i.e. USD 2280.00. The value of 1 pip in this case is USD 10.00. The Forex broker will earn 1 pip spread i.e. USD 10 for your trade. Now as you have USD 10,000 in your account if you put in USD 5560 in your trade, you can go long for 2 lots i.e. EUR 200,000. In this case the value of 1 pip will be USD 20.00 and your broker will earn USD 20.00 for the trade. Larger positions size means more earning for your broker. Life is simple, right?
Is there is a risk for the broker and how Forex brokers earn?
Now the second question – is there a risk for the broker in lending you such big amounts? No, in a normal situation, NOT. Brokers get impacted only when there is some unexpectedly high volatility in the rare cases as what happened during January 2015 when Swiss National Bank reversed their policy to cap the Swiss franc against the euro. The Forex Tsunami on January 15, 2015 cause EUR/CHF to fall by 2295 pips and USD/CHF to fall by 1866 pips in matter of hours. Spreads could not be adjusted, liquidity was not sufficient and client losses became larger than their account sizes and those losses passed over to the brokers.
Well, when you go for a long position for a currency pair, a counter trading party must be on short side for that much amount. If you lose USD 500 then some other trading entity earns the same number of pips and same amount. After all it is a zero sum game. Forex speculative trading is not a cash transaction. Nobody has lent you that money physically. It is just blocking that extra amount.
There is always a market maker behind any Forex trading transaction. Even if you are dealing with an ECN broker, there will be some or another Market Maker at the back of it. This Market Maker is the entity which provides liquidity for the trading. It only blocks that extra amount which makes your USD 2280 as USD 114,000. The blocked money (USD 115,000 – 2280 i.e. USD 111,710) remains there and once the transaction is over, it gets unblocked.
Even if you were trading directly with that market maker and you make a profit of USD 500, what the market maker loses is just USD 500 minus his gains on the spreads. The blocked amount of money over your margin i.e. USD 111,710 remains with him.
Forex Leverages and Regulations
While an individual trader can decide about the leverage for trading for himself or herself, various financial regulatory agencies in different countries may also set restrictions to limit the leverage a Forex broker may offer in that country or economic zone. These restrictions are mainly to protect the interests of the investors and traders.
Maximum Forex Leverage in U.S.A.
In 2010 CFTC (Commodity Futures Trading Commission) had restricted the maximum leverage limit for retail Forex trading for CFTC regulated US Forex brokers as follows:
- Currency Majors: 1:50.
- All Other Currency Pairs: 1:20.
History: Before 2009 leverage up to 1:400 were permitted in the U.S. In 2009 the maximum limit was brought down to 1:100.
Maximum Leverage in Japan
JFSA (Japan Financial Services Agency) had restricted the maximum leverage allowed for retail Forex trading transactions to 1:20 in August 2011.
Maximum Leverage in South Korea
South Korea came out as with the strictest regulation by which the maximum allowed leverage is limited to 1:10 by the regulatory body FSC (Financial Supervisory Commission). This latest leverage restriction was put from March 2012. Before this in September 2009 FSC had brought down the maximum leverage from 1:50 to 1:20.
- Forex Margins and Leverages