How to Understand Leverage & the FOREX Exchange

The use of leverage, the funding of a trading position with borrowed funds, is a fundamental basis of trading foreign currency. FOREX trading is about balancing currencies among trading nations all over the world, so large trading volumes are always in play. Daily currency price moves are relatively small. Traders carry large risk positions to amplify profit opportunities.

Calculation of FOREX Leverage

• 1

  Trade FOREX in notational amounts. Notational amounts refer to commonly traded currency amounts. For U.S. dollars, notational amounts are regularly $100,000 and $1 million. Margin amounts refer to the monies the trader needs in order to control a certain notational amount. Usually this amount is 1 percent to 2 percent of the notational amount. This means the trader is margined 50 to 100 times his deposited margin.

• 2

  Leverage FOREX to maximize your trading position, but control the money at risk. The FOREX broker will close your trade if the value of your margin is exceeded. You are responsible for all losses that may result. In most FOREX trading a minimum margin or 1 percent to 2 percent is typical of the daily swings of most currencies, called volatility. Consequently, traders must be prepared to contribute more than the minimum amount of leverage needed to trade FOREX.

• 3

  Professional traders use FOREX as either a hedge or a speculation. Hedges are used to offset the risk from the ownership of another currency and reduce the need for margin. For example, owning German stocks and shorting the Eurodollar involves offsetting currency risk but still maintaining equity risk. The margin in this case is the pledge of the value of the German stock as collateral. The trader expects for the stock to rise in value while protected against major currency moves.

• 4

  Understand FOREX margin requirements carefully. There are two components to the margin requirement. One part is the margin required to take on the trade, usually 1 percent to 2 percent. Illiquid currencies demand higher margin levels. The second component is called maintenance margin, the margin needed if the initial margin is depleted. Different brokers on different exchanges have different rules for margin and maintenance. Exchanges around the world differ in the types of currencies they offer for FOREX trading.

• 5

  Maintain the level of margin in the margin account at minimum levels at all times. Because account valuations change every few seconds margin requirements constantly change. Exchanges require brokers to be able to call additional margin from the trader's account if the initial margin is no longer sufficient to meet exchange rules. If the trader cannot supply the maintenance margin because of adverse market swings, the account will be liquidated. This does not remove the trader from further trading losses until the margin is met.