What Is Leverage?

Leverage and margin system are the basics of trading. Understanding their working mechanism is important for everyone who wants to trade in the financial markets.

Why do we need leverage?

At its inception, the currency market was limited to large investors with large capitals. It allowed them to make good profits from the narrow-range movement of currencies. 

With the development of the market and the emergence of brokerage firms, the so-called leverage and margin system were devised. They enabled small traders to trade in the markets and make profits. 

Definition

The concept of leverage in the financial markets is the ability to control or trade in very large amounts by using a very small amount of money. Leverage is a facility provided by the brokerage firm to a trader so that they can trade in multiples of the size of the capital they own.

For example, if the brokerage firm provides leverage 1:50, this means that the company provides the trader with the ability to trade 50 times the volume of their deals in the market.

The brokerage company provided the trader with a facility that makes his deals in the market reach 50 times the size of the original deal. The facility will be returned to the company directly after the closing of the trading deal. The profit or loss achieved from the deal will be calculated and added or deducted from the trader’s capital.

To clarify, you open a trading transaction on EURUSD with a value of one thousand dollars. This transaction in the market will have a value of 50 thousand dollars due to the leverage of 1:50. This is what makes the percentage of profit or loss compared to the original amount very large.

Leverage size

Forex brokers provide many sizes of leverage: Some brokerage firms offer leverage that exceeds 1000 times the capital. The most popular leverage sizes include 1:20, 1:50, 1:100, and 1:200.

Leverage 1:100 means that every dollar you use in your trades will be increased to $100 in the market while opening trades. Look at the examples of different leverage values:

Leverage mechanism and margin system

Leverage works through a system called the margin system or margin. The system of leverage and margin is one integrated system that is inseparable from one another.

A margin is a small amount of capital that is reserved to allow the trader to open a new trading deal in the market. This amount is determined based on the size of the Forex trading contract in addition to the amount of leverage. 

Margin is not a fee or commission. It is a guarantee that the trader will be able to keep an open position in the market. The margin is returned to the account balance after closing the transaction. The trading broker uses the margin amount to protect traders’ positions and to cover any losses that may occur to the account during trading.

The value of the required margin is very small compared to the size of the trading position in the market

An example

Let's say a trader has an account balance of $1,000. A brokerage firm offers 1:100 leverage. The trader wants to open a long (buy) position on the USDCAD pair.

With a mini contract of 0.10, that is, its quantity is 10,000 units of the base currency, which is the US dollar.

Without the financial leverage, the trader will not be able to execute a purchase transaction for 10,000 dollars with an account size of 1000 dollars only.

With the margin and leverage system, the trader will be able to open the positions. The company opens the contract for the trader. In exchange for that, the broker reserves a certain value of capital corresponding with the size of the contract and the financial leverage.

It is called the reserved margin and is calculated by dividing the value of the contract by the value of the leverage:

$10,000 ÷ 100 = $100

So, the $100 reserved margin will be deducted from the capital, leaving $900 in the account, which is the available (or free) margin.

If the deal is closed with a profit of 120 dollars, this money is added to the balance.

The company will return the margin reserved ($100) to the account so that the balance becomes equal to 1120 dollars.

But if the closing takes place after losing $50, it will be deducted from the balance. The brokerage company will also return the reserved margin to the account, and the balance will be $950.

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