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 offers potential opportunity, but it’s also quite risky.
Money never sleeps, and neither does the foreign exchange (forex) market. More than $5 trillion of currency changes hands globally every day, according to the Bank for International Settlements. And because global economic forces constantly change, the forex market is in perpetual motion. But traders and investors who understand forex market dynamics—including the use of margin—can identify opportunities to capitalize on the headlines and the many developments that drive the U.S. dollar, euro, and other currencies.
“Geopolitical tensions, economic news, central bank policy decisions … a multitude of things move the forex market every day, and so there are several different reasons to consider using margin in forex trading,” said Adam Hickerson, senior manager, futures and forex at TD Ameritrade.
Margin, also known as 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 down. But margin can also magnify losses. In forex and other markets, margin can cut both ways, according to Hickerson. “How much are you willing to risk and how much leverage do you want to use?” Hickerson asked. Whether you use margin, and to what extent, “it’s a matter of your overall risk tolerance,” he explained.
What is leverage in forex, and how does it work? It’s similar to margin trading in stocks and futures, but there are key differences.
In foreign exchange, you’re trading two currencies against each other as a “pair,” meaning you’re effectively buying one currency and selling another at the same time. For example, you might trade the U.S. dollar versus the Canadian dollar (USD/CAD) or the Japanese yen (USD/JPY). Sometimes, the currency symbols are flipped, such as the euro versus the U.S. dollar (EUR/USD) and the British pound versus the U.S. dollar (GBP/USD).
A forex currency pair quote tells you the cost to convert one currency into the other. For example, in mid-September, it took about $1.10 to buy one euro. Meanwhile, USD/CAD was trading at roughly 1.33, meaning one U.S. dollar was equal to $1.33 Canadian.
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 three different sizes: standard lots (100,000 units of a currency), mini (10,000 units), and micro (1,000 units).
In the stock market, 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 you already hold can be used as collateral, and you pay interest on the money borrowed. For both equities and forex, margin is the minimum amount of capital required to establish a position.
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Forex trading may be applied to play a short-term hunch on an election outcome, a long-term assessment of the economic path of a country or region, or for many other reasons.
Suppose you expect 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 in September 2019) to control 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 and micro lots tailored to retail traders, pips are worth about $1 and $0.10, respectively.)
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 TD Ameritrade forex account, the position will automatically be closed.
Here’s one difference: In the forex market, margin constitutes a good-faith deposit placed with a broker. 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 (the base currency is always the first currency in the pair. In the case of EUR/USD, the euro would be the base currency; the second currency is referred to as the ‘quote’ currency).
A 2% margin requirement for a EUR/USD position, for example, provides 50:1 leverage, meaning that for every dollar of margin, you’d control about $50. If EUR/USD is trading at $1.10, the total margin requirement for a standard lot position of 100,000 units would be $2,200, which controls a total position value of $110,000 (0.02 x $110,000 = $2,200).
In forex, it’s important to track the base currency versus the quote currency because margin requirements are calculated using the base. According to Hickerson, even if the base currency isn’t the U.S. dollar, margin still needs to be converted to U.S. dollars. Why? Because the U.S. dollar is almighty in many ways, including in forex.
“Currency prices change every day, meaning margin requirements for forex positions may also change every day,” Hickerson said. “It’s important to understand that if the base currency is anything other than the U.S. dollar, the margin requirement is going to fluctuate on a real-time basis as the price of 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 TD Ameritrade client trading forex on the thinkorswim platform, these margin calculations are automatically tracked for you.)
Margin calls are always a risk in margin trading—in any market. If a trade moves against you and your losses exceed the margin funds set aside, it can trigger a margin call, meaning your broker may require that additional money be deposited immediately.
According to Hickerson, forex margin call procedures vary depending on the broker. At TD Ameritrade, 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.
Hickerson noted that margin requirements reflect volatility in the underlying currency pair, which in turn reflects geopolitics, economics, and other factors. That means 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 (the so-called exotics), margin requirements may reach 20%. Hickerson cited Thailand’s baht as a recent example.
Forex trading can offer potential trading opportunities for both the short and long term. Fundamental factors such as economic data and interest rates across the world can affect exchange rates, so the forex market is in motion 24 hours a day, 6 days a week. But if you’re interested in participating, make sure you understand leverage in the forex market. For more on forex margin, watch the video below.
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