What is leverage in the forex market? It’s the ability to buy and sell foreign currencies while putting up only a fraction—3% to 5%—of the notional amount. Leverage, or forex margin, offers potential opportunity, but it’s also quite risky.
The foreign exchange (forex) market provides a way for various entities to buy, sell, and exchange currencies. The forex market includes banks, central banks, companies, firms, hedge funds, retail forex brokers, individual investors, and traders. As the largest financial market in the world, the forex market offers opportunities for hedging and speculating.
Much of the trading done in the forex market involves margin, also known as leverage. The use of leverage can boost an investor’s buying power and flexibility, potentially amplifying gains in a forex position with only a relatively small amount of money invested. However, margin can also magnify losses that can include more than your initial investment. Understanding the dynamics of margin in forex trading can help qualified traders assess if the trading risk matches their tolerance.
The forex market involves trading two currencies against each other as a pair, effectively buying one currency and selling another at the same time. For example, a trade might include the U.S. dollar versus the Canadian dollar (USD/CAD) or the Japanese yen (USD/JPY). Sometimes, another currency is listed first, such as the euro versus the U.S. dollar (EUR/USD) and the British pound versus the U.S. dollar (GBP/USD). The base currency is the first listed in the pair, while the second-listed currency is considered the quote currency.
A forex currency pair quote indicates the cost to convert one currency into the other. For example, it might require 1.10 U.S. dollars to buy one euro. At the same time, USD/CAD might trade close to 1.35, meaning one U.S. dollar is equal to 1.35 Canadian dollars. Quotes can change several times throughout the day.
A pip (short for percentage of a point) is the minimum price fluctuation in a currency pair. It’s often taken out four decimal places. For most pairs, the pip is 0.0001 (except for JPY pairs, in which the pip is 0.01). Most currencies are traded in lots through brokers known as forex dealer members at two different sizes: standard lots (100,000 units of a currency) and mini lots (10,000 units).
Trading on margin is available in both the equities and forex markets, but the mechanics on how margin works has some key differences. With equities, margin trading typically means a brokerage firm lends an account owner a portion (typically 30% to 50%) of the total purchase price, which boosts buying power by a commensurate amount. Securities already held can be used as collateral, and the trader pays interest on the money borrowed.
In the forex market, though, margin constitutes a good-faith deposit placed with a broker in order to open and maintain a position. Here, margin is not a borrowing cost or interest, but is a portion of the trader’s account balance set aside while the forex position remains open. For the most actively traded major currency pairs (such as EUR/USD, USD/CAD, and USD/JPY), the margin requirements are typically 2% to 5% of the notional value of the base currency.
A 2% margin requirement for a EUR/USD position, for example, provides 50:1 leverage, meaning that if the total position value for the EUR/USD position is $50, the margin requirement needed for the good faith deposit will be $1. If the EUR/USD is trading at 1.10, the total margin requirement for a standard lot position of 100,000 units would be $2,200 (0.02 x $110,000 = $2,200) and would have a total position value of $110,000.
Margin requirements are calculated using the base currency. However, even if the base currency isn’t the U.S. dollar, margin still needs to be converted to U.S. dollars. Most brokers only allow their customers to hold U.S. dollars in their account. At Charles Schwab Futures and Forex, only U.S. dollars can be physically held in the forex account. As a result, the margin requirement fluctuates as the base currency changes relative to the U.S. dollar.
For example, if the margin requirement is 5% for GBP/USD, a position of 10,000 GBP/USD carries a margin requirement of 500 British pounds. As the pound fluctuates against the U.S. dollar, the margin requirement for that position will also fluctuate. If you’re a Charles Schwab Futures and Forex client trading forex on the thinkorswim platform, these margin calculations are automatically tracked for you.
As an example, let’s assume a trader expects the euro to strengthen against the U.S. dollar. Buying (or “going long”) one standard lot (100,000 units) in EUR/USD would require a margin deposit of about $2,200 (based on a 2% margin requirement and the EUR/USD exchange rate) to hold a position worth $110,000.
If the euro strengthens to 1.11 from 1.10 (slightly less than 1%), the position would gain 100 pips, or $1,000, for a total value of $111,000. For many currency pairs in a standard-lot trade, a pip is equal to 1/100 of a cent, or $0.0001. (In this example, one pip is worth $10; for mini lots tailored to retail traders, pips are worth about $1.)
However, if the euro weakens instead, losses will pile up quickly. If the EUR/USD slips to 1.09 (a drop of 100 pips, or a bit under 1%), the total position value would drop by about $1,000, down to $109,000.
If it drops another 65 pips, the position loses $1,650, which means only $550—or 25%—of the initial margin deposit is left. If there’s no additional equity in the Charles Schwab forex account, the position will automatically be closed.
Margin calls are always a risk in margin trading—in any market. If a trade moves against the trader and losses exceed the margin funds set aside, it can trigger a margin call, meaning the broker may require that additional money be deposited immediately.
Forex margin call procedures vary depending on the broker. At Charles Schwab Futures and Forex, if the equity in a forex account falls to 100% or less of the required margin level as of 3 a.m. CT, all forex positions are automatically closed. In addition, if at any time the account equity falls to 25% or less of the required margin level, all forex positions are automatically closed.
Additionally, margin requirements can change as events at local, national, or international levels unfold. For some less actively traded currency pairs linked to historically unstable countries (sometimes called “exotics”), margin requirements may reach 20%.
Forex trading can offer potential trading opportunities for both the short and long term, but there are also risks associated with forex trading like losing more than the initial deposit. Fundamental factors like economic data and interest rates across the world can affect exchange rates, so the forex market is in motion nearly 24 hours a day, six days a week. Before participating in the forex market, traders should understand the risks of leverage in the forex market.