You need to understand margin and leverage. These are two of the most important terms in Forex trading. The margin is the security that you must deposit with your broker for a foreign exchange trade. A margin of 0.5% means that you use a guarantee of 500 € when executing a trade for € 100,000.
The leverage is the reciprocal value of the margin. A margin of 0.5% equals a leverage of 200:1. When you buy and sell foreign currencies with a leverage of 200:1, it means that with 500 € in your Forex broker account you can trade 200 times that amount, ie 100,000 € in a Forex trade.
You might have already realized what a low margin respectively a high leverage imply: large potential gains and a high level of risk. Let’s look at an example.
Example Margin and Leverage
You expect that the USD will be weaker against the euro in the short term. Therefore you buy Euros and sell Dollars for the same amount of money. With you Forex broker, you can trade with a margin requirement of 0.25% (and a leverage of 400:1). You invest € 1,000. This allows you to trade currencies with a value of € 400,000. If the euro is rising by half a percent against the dollar, then you have 402’000 €. So you invested € 1,000 to make a profit of € 2,000, which corresponds to a return of 200%, even though the euro has increased only by 0.5%.
What happens if the Euro depreciates against the U.S. dollar? Then your money is lost quickly. A decrease of the Euro by only 0.25% would reduce the value of your position to 399’000 €. Your margin of € 1,000 would be gone. Most brokers will automatically liquidate the position in such a case. The small price movement in the wrong direction by a quarter percent thus has led to a loss of the total invested amount of 1,000 €.
High Leverage and Low Margin: Good or Bad?
The greater the leverage, the more profit you can achieve with a certain capital, but the higher your risk is. Hence, a high leverage is not better or worse than a lower leverage: the higher potential rate of return is offset by a higher risk of loss.
Different Leverage / Margin
The margin requirements are not the same for all currencies and brokers. In general, the margin for the most traded currency pair EUR/USD is the lowest. This currency pair can be traded with a leverage of up to 1000:1. For less liquid currency pairs, i.e. currencies that are traded less, the margin requirements can be much higher, for example 2%, representing a leverage of 50:1.
Not all brokers offer the same leverage. An overview with the maximum leverage can be found on our Forex broker comparison table.
Extra Tip
If you are beginner in Forex trading, we recommend you to to start trading with a free demo account first. With a demo account, you can trade under real conditions without risking real money. You should trade with real money only when you are very familiar with Forex trading. And even then you should operate only with small amounts of money and trade only with fractions of your assets that you can lose completely.
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