Technically, leverage is where a trader has a large sum at their disposal while using a significantly smaller amount of their own funds. They effectively borrow the rest from their broker.
For example, if you’re trading with a 1:100 leverage, and you have $1,000 USD in your account, you’ve got $100,000 available for trading. Although this sounds like an insanely good opportunity, you must always remember that it’s a double-edged sword.
When you trade with a larger amount, as leverage enables you to do, you can open bigger positions and potentially earn larger profits. However, with bigger positions you also have a higher risk whereby your losses could also be larger.
It may be easier to understand if you think of the margin as a deposit for the trade that you want to open and maintain. The broker that you’re trading with will keep a portion of your balance to cover the potential loss of that trade. Once you close the position, the margin will be put back into your account.
The margin that you need for a trade is normally expressed as a percentage of the whole trade and is called the ‘Margin requirement’. You’ll be given a margin requirement for every trade that you open, and it will vary depending on the instrument that you trade and the broker that you choose to trade with.
Well, the required margin will be a percentage of the size of the trade that you want to open and is calculated according to the base currency of the pair that you want to trade. Using the equation below you can work out how much margin you’ll need for each trade.
Required Margin = Position Size X Margin Requirement
You’d like to open a mini lot (10,000 base units) in USDJPY. How much margin do you need to open the position?
As the USD is the base currency, the position size (or notional value) is 10,000 USD. Your broker has given you a Margin Requirement of 5%.