Risk Warning: Your capital is at risk. Statistically, only 11-25% of traders gain profit when trading Forex and CFDs. The remaining 74-89% of customers lose their investment. Invest in capital that is willing to expose such risks.

Concepts Every Trader Should Understand: Leverage, Margin And Hedging

Author: Martin Moni
Martin Moni
All publications of the author

In every field, there are certain terms that are often used to describe the various unique elements in that particular field. This is the same with the retail FX industry, where there are some unique terms you are very likely to encounter. Not only should you know about them, but you need to know how these features affect your trading career. To this end, we shall highlight the most important concepts for you to know about.

Margin and leverage in FX trading: what’s the difference?

The terms leverage and margin are common in the FX industry among FX brokers, and they are often used interchangeably. Nevertheless, these two terms represent different ideas that every FX trader should be aware of if they are going to make proper decisions in their career. In this post, we shall look at what each of them mean and their pros and cons. They are often used interchangeably because they both involve borrowing, but there are some differences. (Some of the: Types of FX trading accounts)

What is leverage and which technology supports it?

Financial arenas had always been the purview of the rich in the past. Today, you may find the idea of trading the FX arena with $1,000 as a common notion, but your parents and grandparents may not find it so easy to comprehend. You see, the ability to trade with only a little amount of capital is actually less than two decades old. Today, you can trade with the ‘fat cats’ on Wall Street just because of leverage, a simple concept that revolutionized the financial industry. (Some of the: Changes In FX Regulation Through MiFID II)

What is leverage?

The easiest way to think of leverage is to look at it like taking debt to finance an investment. Say, you wanted to buy one lot of the GBP/USD pair, but only had $1,000. One lot of any currency pair usually involves 100,000 units, so one lot of the GBP/USD pair would be worth about $130,000 at the current exchange rate. However, your FX broker would still like to give you a leg up, so they decide to take your $1,000 and essentially multiply it by 100. This is a 100: 1 leverage, because you’re getting 100 times as much capital for every unit you put in. Now with just $1,000, you can control $100,000 worth of trades, and this would let you buy one lot of the GBP/USD pair. (Tips on: Risk-management on FX)

Is there any benefit to using leverage?

The concept of leverage not only allowed more people to participate, but also maximized the gains that could be had. Let’s go back to our example; picture a trader who put up $1,300 to buy one lot of the GBP/USD pair at a rate of around 1.3. If the exchange rate rose to just 1.4, the profits from the trade would be $10,000, and all of that would go to the trader. Considering he had just put up $1,300 for the trade, that would be a remarkable return. Of course, there are downsides to leverage, but traders choose to focus on the positive, which is why so many of us have joined the FX arena. (The: 10 steps of successful traders)

What impact has leverage had on the financial markets?

As you can imagine, many people did not have enough capital to participate in financial arenas. As we just saw, just one lot of the GBP/USD pair took more than $100,000 and that was the minimum. With leverage, though, more people could participate, and that led to a rapid growth in the retail FX arena. Since leverage was introduced, there has been a remarkable increase in the number of FX brokers and the number of retail traders. Of note, however, leverage in the retail FX industry is still fairly new, and it coincided with the rise of the internet. In fact, this has been the main driving force that made leverage possible. (Learn: How to create a trading strategy)

How has the internet made leverage possible?

You may ask yourself why leverage was not available before the internet became so widely available, and it’s actually quite simple – numbers. By offering leverage as high as 100: 1 and even 1000:1 in some cases, the FX brokers are taking a huge risk. In case the trader ends up making money, that is a huge loss on the part of the broker. Considering one trader can make as much as $10,000 with just $1,000, this would seem like an unnecessary risk, until you look at the statistics. (Here is: How to find best FX spreads)

Often, only as little as 5% of traders make money while the rest are losers. With the advent of the internet, FX brokers could sign up a lot more traders from all over the world. With more traders come more losers, and those count as a profit to the broker. Even if a few traders make a lot of money, the losses from the rest would make it up and then some. Besides, there are always new traders to sign up thanks to the internet, and this means the business can continue to operate. (What Is The Financial Commission And Can It Be Trusted?)

Therefore, the internet can be considered to be the main driving force behind the popularity of leverage and indeed, the growth of the retail FX arena as a whole. Apart from that, FX trading platforms mean that the FX arena is available on multiple devices for traders to gain access to the arenas. These two factors have helped make leverage crucial in boosting the FX market as a result. (Learn how to use: The Keltner Channel Indicator FX Trading Strategy)

How is margin different from leverage?

Whereas leverage is taking on debt to finance an investment, margin is akin to a good faith deposit. In the above example with leverage where the FX broker allowed a trader to control a position worth $100,000 with just $1,000, you could say the broker provided them with a 1% margin. That is the first difference between the two – margin is expressed as a percentage while leverage is a ratio. In the case of margin, a FX broker requires you to put in 1% of the trade value as a show of good faith before they can provide you with leverage. (More about: Exchanging the FX arenas based on free arena activity)

As you can see, the two concepts go hand in hand, but they are not exactly the same. Therefore, you should try to avoid using the two terms interchangeably because they don’t mean the same thing. However, since one does lead to another, here is a cheat sheet you might use to see how leverage and margin relate. (Learn How To Use Position Trades In The FX Arena)

Cryptocurrencies can be now traded on margin as CFDs

For FX traders, the concept of margin trading is very familiar. However, the crypto market has only recently started to offer trading on margin for several coins. So far, only a handful of crypto exchanges provide the crypto margin trading service, but it represents a significant step in the industry. On the other hand, trading on margin presents some risks, which you may want to avoid. Before you decide whether you find the crypto margin trading option useful, it is important to know exactly what it is. (TRON Predictions And Forecast For 2018 And Beyond)

What is involved in cryptocurrency margin trading?

Simply put, trading on margin is similar to borrowing extra money in order to make a bigger trade, just as you would in the FX arena. For example, imagine if you had just $1,000 to buy, say, Bitcoin (BTC). With your capital, you would only buy $1,000 worth of BTC, which at the current value of about $9,500, would be about 0.1 BTCs. However, you can borrow a little extra money and buy about double of that. If the crypto exchange were to give you another $1,000, then you would have 0.2 BTCs. (Complete: Ripple Price Forecast, Making Money Moves!)

After you have closed the trade, for example you sell your BTCs later, all you have to do is pay back the $1,000 you borrowed from your exchange. Most exchanges will only ask for their margin back, but others may impose an interest or other additional costs. This process of borrowing money in order to make a bigger trade is what we refer to as crypto margin trading. (These are the: NEO Price Predictions And Forecast For 2018)

To trade or not to trade cryptocurrencies on margin

The leverage to this crypto margin trading is obvious – you get to earn more profits. In our example above, assume that the value of BTC rose to $15,000 in a few weeks or even days. The trader could sell their 0.2 BTCs for $3,000, thereby making a $2,000 profit and paying back $1,000 to the broker for a $1,000 net profit. Had they just bought 0.1 BTCs without margin, the return would be $1,500 for only a $500 profit. Clearly, the amount of margin offered increases the potential profits from the trade. (Have you ever asked yourself: What Is The Future Of Cryptocurrency In Finance?)

All the same, there are some nasty downsides to crypto margin trading. Even though you can make double or even more in profits through margin, so can you suffer when the arenas move against you. Imagine if the value of BTC fell to $5,000 and the trader closed the position. They would only be left with $500, but would still owe the exchange $1,000 therefore suffering even more losses as they would have to deposit another $500 just to cover the losses. Furthermore, crypto margin trading can have a lot of extra charges in the form of interest or commission. All of these fees may eat into your profit making it uneconomical. (This is: How to protect yourself from margin call)

Where can I find crypto margin trading?

If you’re still reading this, then you have decided that crypto margin trading is good for you. If so, some prominent exchanges offering the service include Coinbase’s GDAX, Poloniex and Kraken. It is important to understand the conditions for margin trading from all the above exchanges first because they vary. It is only when you fully understand what the conditions are that you should delve into it, lest you find yourself encumbered by unexpected fees and conditions.

What about hedging in FX?

The term hedging is often heard from stock traders and other major investors, but the concept can also be applied to FX trading. First, though, we should begin by explaining what hedging in the FX arena is before recommending whether to do it or not. We have discussed hedging before, but this topic needs more in-depth analysis, so here goes… (All about: Hedging)

What is hedging in FX?

By definition, hedging means making a trade intended to reduce the risk that could arise from an existing trade. For example, imagine a trader that is long on the EUR/USD pair, but the FED is just about to announce a change in interest rates. The trader does not know how the FED will change interest rates, and their existing long position on the EUR/USD could be risky. (Find out more about: Currency correlation and how to use it)

How do you hedge FX arenas?

Typically, you would be advised to close this position, but the other alternative could be hedging. Since the US dollar is the one currency that is in limbo, you could make another trade based on the US dollar in case of any sudden moves. The trader could, say, short the USD/CHF pair. That way, even if there are sudden moves on the dollar to the downside, the second trade would compensate for any losses. (These are the: 10 rules of how to earn money with scalping)

The method of hedging discussed above is the conventional form of hedging, and it is even used by traders in other arenas. However, there is a more direct hedging solution, one that allows you to buy and sell the same currency pair concurrently. In our previous example, the trader could have sold the EUR/USD pair without having to close the existing long position. The only problem is that not all brokers allow this direct kind of hedge in the FX arenas. The top: Secret of Monday's Gap Trading)

What is the benefit of hedging?

The main reason to hedge is to prevent significant losses on your account. Imagine the situation described above, if the FED decided to lower interest rates. The US dollar value would probably drop sharply, taking away most of the profit from the long position. By hedging using another US dollar-based currency, the decline in value would bring in profit to offset the losses from the first trade. Even through direct hedging, this is still the main reason people hedge in the FX arena. (Are these: The Top 5 Coins To Buy In 2018?)

Other than risk management, hedging can be a clever tool for maintaining your account balance. If, for example, you were holding a losing trade and your margin was diminishing, hedging can help bring your margin back up so you can continue trading other currency pairs. A direct hedge position cancels out its opposite trade so that your account margin remains intact for additional trades. (Find out: How Coin Scams Operate And How To Avoid Them)

Why hedging may not be recommended

Even after fully understanding what hedging is by definition, it is still a complicated process of trading that could result in even more losses. Imagine a trader who has done a direct hedge on the same currency pair; as one position runs losses, the other makes a profit. However, this process could keep going on for a long time, all the time accumulating swap charges and other costs. To make such a hedge work, it would require foresight to predict arena moves that could result in a profitable conclusion. (What Would Happen To BTC When It Is All Mined?)

Unfortunately, many traders perform market hedges even without complete understanding of the concepts and end up making higher losses. The main problem with hedging, therefore, is that it is a risky move and it should only be performed by traders with a deep proficiency in market movements. (The complete: WAX coin forecast for the year 2018)

Should you do it or not?

If you learn how to do it well, then it can be a useful tool, but until you have practiced, it’s best to keep away.

Parting shot

Similar to most fields, the FX industry is also all about continuous learning. Finding out as much as you can about your area of expertise will not only help you to be more eloquent, but will also help you to comprehend new lessons acquired from other experts in the field. To find out more about the importance of language, just listen to this TED talk about how language shapes our thoughts:

Was the article useful for you?
5 (1)

Risk Warning: Your capital is at risk. Statistically, only 11-25% of traders gain profit when trading Forex and CFDs. The remaining 74-89% of customers lose their investment. Invest in capital that is willing to expose such risks.