TRADING BASICS

Courtesy of DailyFX.com

Leverage: Trading With Borrowed Funds

Simply put, leverage is the ability to trade with borrowed funds. Leverage is a tool by which traders can determine the level of risk - and thus, the potential reward -- they assume in the market. The more leverage used, the more volatile the trader's percentage return of profit or loss can be.

An example of how leverage used in trading is as follows:

Suppose a trader purchases 1 lot of USD/JPY - a trade that involves the purchase of 100,000 US dollars - at a rate of 116.65. Instead of depositing 100,000 US dollars into his account to place the trade, though, the trader deposits 10,000 US dollars - and uses the leverage afforded by his trading firm to purchase the remainder of the position. Mathematically, a trader's leverage ratio is the value of the position they assume divided by the value of their account balance. In the example above, the position size is $100,000 and the account balance is $10,000 - thus making leverage 10:1 (100,000/10,000).

Now assume the market moves in favor of the trader, and that the rate jumps to 117.65 - 100 pips above his rate of entry. The trader now seeks to exit the trade. At the exchange rate of 117.65, his 100 pips on the USD/JPY are worth approximately $850. On the total $100,000 investment, this amounts to a paltry return of just 0.85%. On a $10,000 investment, though, the return is 8.5% -- an impressive amount for a single trade. Clearly, leverage can be a critical tool in determining the amount of risk traders assume and the ultimate return on investment they receive.

In most FX trading, clients are not required to pay for the entire value of the lot, or currency, they purchase. Instead, they are only required to pay for a portion; the rest is given to the trader on the basis of good faith. The required amount that is needed to put up is referred to as margin. Often, it is expressed as a percentage; for instance, if a trader purchases 1 lot of USD/CAD - which is the equivalent of 100,000 US dollars - and his FX trading firm requires a deposit of $1,000 per lot, the margin requirement as a percentage is simply 1%, as the dollar value of the margin requirement ($1,000) is 1% of the total value of the position ($100,000).

Margin Call: Protection When Trading With Leverage

A margin call occurs when the trader's account equity - the total value of the account, including balance and open positions - falls below his margin requirement. At this point, dealers may begin to close out positions, thus ensuring that clients can never lose more than they deposit.

account balance + value of open positions < margin requirement = MARGIN CALL

One of the obvious dangers of trading on margin is that should the value of the position fall substantially, the trader's deposit could easily be wiped out. Meanwhile, the position could continue to fall, thus exposing the trader to substantial liability. Such scenarios are common in futures and equities market, and thus margin trading is more dangerous in those arenas.

Next: Calculating Profit and Loss