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    Understanding Leverage and Margin in Forex

    You may have heard references to 400:1 leverage being available on ForexCT accounts, but what does this actually mean? Let’s take a look at the basics of leverage and margin in Forex as well as ways to manage risk on your trades.

     
    Let’s begin with the basics… by understanding what a ‘pip’ is

    You may already be familiar with the basic trading terms, but let’s cover them for the sake of clarity. A pip is the number value assigned to the movement of an asset. With most currencies, one pip equals 0.0001. For gold, oil, most indexes and the Japanese yen, the pip sits two positions to the right of the decimal instead.

     
    What’s a pip worth?

    That depends on the value of the trade and the current exchange rate. To calculate this, you can divide one pip in its decimal form by the exchange rate, then multiply by the notional amount of the trade.
    e.g. 0.0001 divided by 1.1300, then multiplied by a position of 100,000 for a $8.84 value per pip.

     
    What is the spread?

    The spread is simply the cost of the trade, being the difference between the bid and ask price. That cost is determined by the amount that you trade and will be recalculated and translated from a pip value into the currency of your account (which is AUD or USD with ForexCT).

     
    What is margin?

    The margin is an amount from your account balance that is needed to open a leveraged position. Think of margin as a form of collateral. If your broker requires a 2% margin, then that margin will need to be available as cash in your account. Margin requirements increase along with trade size.

     
    What is leverage?

    If we only traded using our account equity our potential returns are limited to this amount. Instead, we can use leverage, or borrowed funds, to be able to gain exposure to larger positions. You fund the required margin and the broker (in this case, ForexCT) foots the rest of the notional position until the trade is closed. Leverage is somewhat of a double-edged sword in that it can both magnify your profits but also your losses. The greater the leverage, the greater the risk and potential reward, as can be seen in the following example between Trader A and Trader B.

     
     

      Trader A Trader B
    Account Equity $1,000 $1,000
    Margin $20 $20
    Leverage Used 200:1 (200 times 20) 50:1 (50 times 20)
    Notional Trade Size $4,000 $1,000
    100 Pip Profit OR Loss in Dollars $30.30 $7.50

     
    What is risk/reward ratio?

    Risk/reward ratio helps you to judge the potential pros and cons of a trade. If you trade 50,000 units of currency and expect to make $1000 from $500 in risk, then the risk/reward ratio is 2:1. Most traders stay away from trades where the risk/reward ratio is less than 1:1, however your own ratio will depend on your trading strategy.

     

    Two measures that can help you to control risk are to use smaller margins as a percentage of your account balance, and to choose lower leverage per trade.

     
    If you’re new to trading Forex, our eBook guide is a great place to start – click here to download this free resource now.