How Leverage and Margin Trading Works
Leverage in business is defined as the use of a small capital or borrowed funds to gain control of a bigger business venture with the view of achieving higher returns from the said investment. It is normal for businesses to borrow capital to finance large ventures. The debt gives them the leverage meaning they are able to make much bigger investments which otherwise their actual meager capital at hand would not allow them to do. The debt therefore gives them the leverage or the opportunity to magnify profits even if they have very little capital at hand.
Retail forex trading is leveraged trading in the sense that a trader uses very little capital of his own to buy or sell large amounts of currencies. The spot foreign currency market in general is a wholesale market where transactions are in the range of millions of dollars. Retail forex trading constitutes just a small portion of the much bigger forex market. With retail forex, individual transactions are done in tranches worth at least $100,000. However, trading in retail forex is done through a leverage and margin trading system where individual investors are allowed to trade lots using only very little money. It is one of the best features of retail forex trading which attracts individual investors to give forex trading a try.
How Do leverage and margin trading system work?
With just a very small capital, an individual speculator can buy $100,000 worth of another foreign currency using as little as $2,000 capital through a broker using the margin trading system. This in effect gives him a 50:1 leverage since his $2,000 allows him to buy $100,000 worth of other currencies like Yen, Euro, British Pound, etc. With a foreign based broker, the leverage can go as high as 400:1. It is only in the U.S. that financial regulators put a cap to the maximum leverage that U.S. based online forex brokers can offer their clients and it is pegged at 50:1.
In effect, the forex broker lends the money required to buy the currencies in tranches. The margin deposit ($2,000 per tranche in this case) of an individual retail forex trader serves as a guarantee to ensure that any obligations he may incur as a result of his forex trading activities will be paid.
How does leverage magnify profits?
The profit potential of a highly leveraged trading can best be explained through illustrations. For example, if you wish to buy 1 lot of USD/JPY (US Dollar versus the Japanese Yen) at the price 96.00 and the price appreciates to 98.00, then the difference will be your profit.
The minimum price change of a currency pair is called a pip. Thus from 98.00 to 98.01 we have 1 pip. Each pip’s value depends on the volume traded and since the retail forex brokers allow you to use a high leverage, you will be able to trade more with less funds. The higher the volume, the higher the pip size, therefore you can earn more or lose more.
This is the power of leverage in retail forex trading which is a direct result of the margin trading system. But before you jump in and give it a try yourself, you must understand that it gives you this unique advantage only if the market moves in your favor. If the market moves against you, it will magnify your losses instead, potentially getting you a stop out where all your trades will be closed automatically to prevent you from reaching a negative balance.
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