When it comes to forex trading, the majority of retail traders use leverage as a tool to multiply their profits. But new traders rarely look at the opposite side of the picture as leverage is a double-edged sword. I am writing this article to try and show you an accurate picture of leverage.
Forex leverage, also known as gearing, is tool traders use to borrow capital to get greater exposure to the FX market. Using leverage, a trader can handle a greater trade size with a limited amount of capital. Leverage works both ways as it may lead to bigger profits and losses if your trade ends in the opposite direction.
The term implies for trading using leverage in forex is forex margin. It allows you to magnify profits if markets move in your favour, but it also makes you lose all of your capital if markets move against you.
Forex trading has some of the lowest margin rates in the financial markets. For example, the leverage difference between forex and stocks is more significant. Stock market leverage begins at roughly 5:1, making stock market trading marginally less risky in terms of capital.
I believe that now you may have the basic idea of forex leverage; let’s head to make it clearer with an example:
Suppose a trader with 1:20 leverage wants to buy $10,000 of GBPUSD or one lot.
To calculate the margin necessary to open a position, divide the total position value by the leverage factor. As a result, in the above example, the needed margin is $500 (10,000/20).
In this case, a $500 deposit is required to gain a $10,000 position exposure. But in reality, the trader will deposit somewhat above $500 ($700 could be a fine number) to satisfy the margin level and free margin requirements.
The leverage ratio compares the total exposure of your trade to the margin requirement. Your leverage ratio will vary based on the market you’re trading in, who you’re trading with, and your position size.
A 10% margin provides the same exposure as a $1000 investment with a $100 margin. This results in a leverage ratio of 10:1.
The lower the leverage available to protect your position from rapid price movements, the more volatile or less liquid the underlying market is. However, extremely liquid markets like forex may have extremely high leverage ratios.
In the example of a $1000 initial investment, here’s how different degrees of leverage affect your exposure (and your potential for profit or loss):
| Leveraged trading | ||||
|---|---|---|---|---|
| Ratios | 20: 1 | 50:1 | 100:1 | 200:1 |
| Outlay | $1000 | $1000 | $1000 | $1000 |
| Exposure | $20,000 | $50,000 | $100,000 | $200,000 |
When exploring leveraged trading providers, you may come across higher leverage ratios – but be aware that employing excessive leverage might negatively influence your positions.
So far, we have discussed that trading on leverage requires allocating a small percentage of your trading account as collateral, or margin, for the trade. The needed margin is directly proportional to the leverage ratio. A leverage ratio of 50:1 necessitates a 2% margin, which implies you must dedicate 2% of the position size from your own capital. A margin of 0.20% is required with leverage of 500:1.
The table below indicates how much margin you need to assign based on your leverage.
| Leverage Ratio | Margin Required (as % of position size) |
|---|---|
| 20:1 | 5% |
| 33:1 | 3% |
| 50:1 | 2% |
| 100:1 | 1% |
| 200:1 | 0.5% |
| 400:1 | 0.25% |
The higher your leverage ratio, the lower your margin requirement. However, while trading on high leverage, you control a massive position size compared to your trading account size. A small market movement against you might lead to significant losses and ultimately wipe out your whole account. In extreme cases, it also leads to more financial costs as you borrow more money from your broker.
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Before deciding on a level of leverage, investors should consider some widely accepted guidelines. The three simplest leverage rules are as follows:
Forex traders should choose the level of leverage that is most comfortable for them. If you are conservative, have a low-risk tolerance, or are still learning forex trading, a lower level of leverage, such as 5:1 or 10:1, may suit you best.
Trailing or limit stops facilitates traders to limit their losses when a trade goes in opposite directions. Limit stops allow investors to continue learning forex trading while limiting potential losses in case the trade fails. These stops are also crucial since they serve to reduce trading emotion and enable individuals to pull away from their trading desks without emotion.
This is where the double-edged sword comes into play since real leverage can potentially enlarge your profits or losses by the same potency. The more leverage you apply to your capital, the bigger the risk you own. The risk is not always tied to margin-based leverage, although it might have an impact if a trader is not cautious.
Let me provide an example to demonstrate this notion. Traders A and B each have a trading capital of $10,000 and use a broker that demands a 1% margin deposit. With some fundamental and technical analysis, they both believe that the USD/JPY has reached a peak and will fall soon. As a result, they are both short the USD/JPY at 120.
Trader A decides to use 50 times real leverage on this trade by shorting US$500,000 in USD/JPY (50 x $10,000) using their $10,000 trading capital. Because USD/JPY is at 120, one pip of USD/JPY is worth approximately US$8.30 for one standard lot, and one pip of USD/JPY for five standard lots is worth approximately US$41.50. If the USD/JPY rises to 121, Trader A will lose 100 pips on this trade, which equates to a $4,150 loss. This one loss will account for 41.5% of their total trading capital.
Trader B is a more cautious trader who decides to use five times real leverage on this trade by shorting USD/JPY for $50,000 (5 x $10,000) based on their $10,000 trading capital. That $50,000 in USD/JPY is just one-half of a standard lot. If the USD/JPY rises to 121, Trader B will lose 100 pips on this trade, which equates to a $415 loss. This single loss equals 4.15% of their total trading capital.
Leverage trading may raise both your profits and losses. Therefore, it requires ultimate discipline to grow your account using leverage. One error might lead to large losses and blow up your account.
So, how should you go about expanding a small trading account using leverage?
Here are a few points to follow:
For example, your first objective should be establishing a small account buffer of roughly 20% of your initial trading account. If you’re trading with $10,000, strive to build a $2,000 buffer by taking low risks and employing 1:1 leverage. This will enable you to trade larger sizes using the profits you’ve just made without risking your initial trading capital.
The next stage in growing a small account is to use the buffer from the previous step to hit the throttle on high-probability trade setups. This entails growing your position size prudently to capitalise on A+ setups and letting your wins run as far as feasible. For example, you may risk up to $500 on any single trade at this level. If you return to your initial $10,000, apply stricter risk management criteria once again until you generate a fresh buffer.
Forex trading using leverage is an aggressive forex trading technique that appeals to daring and opportunistic traders for the epic earning potential that comes with those risks.
Before using leverage in forex trading, go through some realities of leveraged trading.
When forex traders use leverage, they are basically borrowing money from the broker rather than the primary capital in their account.
ATR Indicator - Average True Range — 2023Leverage is often employed when all your account funds have already been invested, making it impossible to open a position to take advantage of a potential profit opportunity. Your brokerage will provide you with a certain level of leverage based on the value of your account, which is based on the ratio of leveraged funds to account funds allowed by the brokerage.
Your broker will charge you interest
Since your broker is lending you money in leverage forex trading, interest will be paid on those funds too.
Many forex brokers impose a fee of 1 to 2 percent every year—but always read the broker schedule of charges to ensure you understand the cost. Some brokers may demand extremely high fees on their leveraged funds, sometimes as much as 5%. This may significantly reduce the profit one can earn via leverage, particularly if you hold the position for an extended period of time.
If your balance falls below your margin maintenance level, you may get a margin call requiring you to deposit cash to compensate for liability. If you do not deposit funds or if your losses are serious enough, your brokerage may even force you to sell certain assets, locking in losses on your leveraged positions.
Because you are required to pay interest for the leverage you employ, many traders prefer to use leverage only for shorter-term forex trades; otherwise, the interest charges generated by a long-term position might eat into your profits and disturb the risk-reward equation.
The relative strength index, momentum indicators, Bollinger Bands, and moving averages may all assist in detecting potential market movements that might generate quick windows of opportunity to gain profits with your available leverage.
While leveraged forex trading has a higher risk than other kinds of forex trading, an experienced and disciplined trader may use this approach to capitalise on timely forex opportunities while maximising their profits. Although the risk should be taken seriously, astute traders may make the most of their leveraged positions by using stop-losses and deep market analysis.
Every forex trader should understand the terms leverage and margin. While leverage refers to the amount of lent money you may invest, margin refers to the minimum account balance that must be maintained in order to prevent certain account issues.
The margin maintenance will prevent account restrictions and enable you to trade freely with your available leverage.
In this guide, I have explained what leverage is and how it works for beginners. To me, the one crucial takeaway from this guide is that you must practice your psychology while dealing with leverage. Never measure the depth of the river with both feet. Work on a hit-and-trial basis and grow your account slowly.
Forex leverage may be a valuable tool for traders, yet, it also has the potential to prone you to significant losses if not handled carefully. So, before using forex leverage, a trader must get in-depth knowledge about it and build a risk management strategy with appropriate account handling.
A forex leverage calculator assists traders in determining how much capital is required to open a new position and manage their trades. It also assists traders in avoiding margin calls by estimating the best position size.
The forex leverage formula is: L = A / E, where L is leverage, E is the margin amount (equity), and A is the asset amount
