Most of the online forex transactions are carried out by margin trading. In fact, when we talk about leverage effect or leverage ratio or margin rate, they all refer to the same thing- “leverage”. Investors establish and maintain a whole contract without making full payment. They only need to deposit a certain portion of money as “margin”, and that’s how leverage works.
It is not difficult for us to calculate the leverage, which can be explained by several formulas:
Margin requirement = total contract value (position) / leverage ratio
Margin rate = margin requirement / total contract value (position)
Leverage ratio = 1 / margin rate
Dealer A, for example, offers leverage of 100:1, which means that the trade can be magnified 100 times. If the investor chooses to buy one standard contract on USD/JPY, i.e. $100,000, the investor only needs to open the position with ($100,000/100 times) = $1,000 as the margin, while $1,000/100,000 = 1% is the margin rate.
If the margin rate is 1%, it means the money you can use will be amplified by 1/1% =100 times.
It is important to note that some brokers may choose to set the margin requirements at a fixed amount, but the formula will never change. As a result, the actual leverage effect will vary with the total value of the contract changes in response to market price changes. In general, most brokers offered fixed leverage, so margin requirements change as the value of the contract changes in response to market price changes.
The relationship between leverage and risk
Margin trading is common in the financial market, which can magnify the scale of investors’ holdings by tens or even hundreds of times. However, at the same time, there may be misunderstandings among people, especially new investors, which links leverage with risk. Leverage allows investors to build up larger positions with less money, but the risk is based on the total value of the contracts held, not on leverage itself.
If an investor holds a contract of $10,000, and unfortunately the price drops by 2%, the loss is $200, no matter using leverage or not, 10 or 20 times with the same contract size, the loss is always the 2% change in the relative price of that contract, equaling $200.
However, some sudden market fluctuations may also cause investors to be forced to close out their positions due to insufficient margin, which is also an additional trading risk. However, with the appropriate use of leverage, the limited size of the positions and more margin deposit, the risk can be controlled.
Therefore, the market always describes leverage as a double-edged sword, meaning that it may bring more profits, but also with an equal loss risk.
Next Article: 20. Why use leverage?
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Risk Warning: The above content is for reference only and does not represent ZFX’s position. ZFX does not assume any form of loss caused by any trading operations conducted by this article. Please be firm in your thinking and do the corresponding risk control.