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Understanding Leverage in Forex

 

Understanding Leverage in Forex – The Ultimate Guide

“Don’t ever make the mistake of believing that market success has to come to you fast. Trade small, stay in the game, persist, and eventually, you’ll reach a satisfying level of proficiency.”

Yvan Byeajee, Author of Paradigm Shift: How to cultivate equanimity in the face of market uncertainty

Leverage is a two-edged sword! I believe that by now you must have come across this statement.

If not, let me be the first to tell you that the statement is true and you will do yourself a great deal of favour by taking time to let this truth sink in.

Most of the new traders coming to the market often overlook risk management. Well, you might be asking what is risk management and how is this related to leverage?

You know too well that Forex trading is a high-risk investment, having said that, for you to survive in this high-risk venture, you MUST devise a plan to manage your risk.

Over leveraging a trading account is a good example of poor risk management.

Take note:

When you overleverage your trading account, you expose yourself to the temptation of overtrading which will no doubt lead to a very short-lived trading career.

If you are unsure of what leverage is, how to use it, when to use it and how much is “safe” for you, then worry not. In this ultimate guide to understanding leverage, I will try as far as possible to answer these pertinent questions.

This guide covers the following sections:

  • What is leverage in forex trading?
  • How does leverage work in forex trading?
  • Practical forex leverage examples
  • How to calculate leverage in forex
  • What is the best leverage to trade forex?
  • Relationship between Leverage and Margin Call

So, lets jump right in!

What is leverage in forex trading?

In forex trading, investors use leverage to benefit or make profits from the fluctuations in exchange rates between the two countries whose currencies are part of a currency pair.

Investopedia defines leverage as the ability to control large amount of money using very little of your own money.

In forex trading, your broker will require you to deposit some money to your trading account (margin) and then depending on the leverage you have chosen, your broker will loan you the amount that is equivalent to the margin chosen.

How does leverage work in forex trading?

As per the definition of the term “leverage”, which I have presented above, you can see that leverage is meant to increase the lot size that you can trade. This means that you get to deposit a relatively low amount and then get the power to trade a relatively larger size.

Without leverage, most retail traders would not be able to afford trading in the forex market.

Remember, I had mentioned that leverage is akin to a double-edged sword. What does this mean?

Well, a double-edged sword  can do you harm if not handled with proper swordsmanship.

Point to remember:

Standard trading is done on 100,000 units of currency.

for a trade of this size, the leverage provided is usually 50:1 or 100:1.

Leverage of 200:1 is usually used for positions of $50,000 or less.

For you to be able to trade $100,000 of currency, with a margin of 1%, you will have to deposit $1,000 into your margin account.

Another important point to remember:

Margin is a good faith deposit that you deposit with the broker so that you can trade.

The broker can then loan you an additional amount, which we call leverage

The broker can then loan you an additional amount, which we call leverage

The leverage provided on a trade like this is 100:1. Forex traders enjoy higher leverage provision compared to their counterparts trading equities and futures.

For equities, most brokers offer a leverage of 2:1 while for futures the leverage stands at 15:1

Perhaps you are asking, why the BIG difference in leverage across the three markets??

The answer is volatility and fluctuations. Equities and futures fluctuate with wide ranges making them very risky for brokers to give huge leverage.

On the other hand, currency prices rarely fluctuate more than 1% during an intraday trading session.

Typically, the amount of leverage provided can either be 50:1, 100:1, 200:1 or higher depending on the broker and the size of the position the investor is trading.

 

We have some high leverage brokers giving leverage of between 500:1 to 3000:1.

Clearly, you must understand that this is a ploy meant to attract you to open an account with them.

But wait!

Leverage is not that bad, on the hands of a professional trader, leverage can be a deadly weapon which he can use to slay the broker

But remember, the brokers are as deadly as the white walkers in the Game of Thrones, so don’t be too corky with leverage lets you end up being slain.

Since the loan (leverage) is collateralized by the cash in your margin account, the money that your broker loaned you does not come free, you must pay it back with interest. If you happen to be a scalper or day trader this might not be a cause for concern; however, if you are a swing trader, might have to pay between 5% to 10% on the borrowed money as interest. This is how the broker makes money off the leverage they extend to their clients.

Perhaps one of the positive sides of leverage is that you can make large profits from a small deposit. How you ask? Hold that thought, I will clarify this by way of examples below. But even before we move to the examples, let me remind you that high leverage also comes with high risk. Have this at the back of your mind, the high leverage equals high returns which can also lead to high losses.

Practical forex leverage examples

For the purpose of explaining how you can use leverage, let us consider the two examples below

Assuming that both Trader A and Trader B start with an account size of $10,000 with leverage of 50:1 and 5:1 respectively then the calculation of their loss in equity will be as shown below

Trader A

  1. Using a ration of 50:1 means that the investor can enter a trade of $50 for every $1 he has in his account.
  2. With a margin of $10,000 available in the account, this trader can take a trade of up to $500,000 at a leverage level of 50:1
  3. In the event that trader A loses 100 pips in a trade his loss will be calculated as 100*50*1= $5000
  4. This translates into a loss of 50% of the account

Have you seen how high that is? Let us now consider the conservative Trader B

Trader B

  1. Using a ratio of 5:1 means that the investor can enter a trade of $5 for every $1 he has in his account.
  2. With a margin of $10,000 available in the account, this trader can take a trade of up to $50,000 at a leverage level of 5:1
  3. In the event that trader A loses 100 pips in a trade his loss will be calculated as 100*5*1= $500
  4. This translates into a loss of 5% of the account

Compare the two scenarios, which one would you rather be in? Which scenario would you stomach? losing 50% of your account in one trade or losing 5%

I think your guess is as good as mine, you `can stomach losing 5% of your account and still be able to trade another day.

As you ponder on the right leverage to you, please be guided by this mantra

In forex, every investor has two main goals-capital preservation and capital growth

The first, which is Capital Preservation, takes precedence over capital growth.

Why you ask?

Simple, you cannot grow what you don’t have. Capital preservation ensures that you have money to trade another day.

Using low leverage will help you achieve the goal of capital preservation.

How to calculate leverage in forex

Before calculating leverage, you need to establish two important parameters:

  1. How much are you willing to risk in a particular trade?
  2. What will be the distance between your entry order and your stop loss?

Assuming that you have an account of $10,000 and you are willing to risk 2% of your account. Then your allowable risk per trade will be 2%*$10,000= $200

Therefore, again assuming that you set your stop loss at 100 pips, your trade size will be given by the formula: Allowable risk/Stop loss= 200/1000= 0.2

Leverage is then calculated by substituting the figures above in the formula: Trade size/initial investment

Therefore, leverage will be 1:500

What is the best leverage to trade forex?

According to dailyfx most traders are attracted to the forex markets because of the wide availability of leverage. Compared to other markets, forex brokers offer larger leverage to investors.

Now, fact that brokers are ready to offer you maximum leverage doesn’t mean that you should go for it.

Leverage, in the right hands, can lead to substantial gains.

But now begs the question, what is the best leverage to trade the forex market?

According to the graph above, you can see that the lower the leverage the higher the winning percentage. If you are planning on joining the group comprising winning traders, then you should consider settling for leverage that is the neighbourhood of 5:1 or less.

Relationship between Leverage and Margin Call

As I have pointed out above, leverage is a loan that is given to you by the broker allowing you to trade bigger position than the margin you have deposited. There is a margin requirement that is normally set by the broker. This margin requirement is what sustains your active trades.

You follow?

Good, now in any case your active trades are in losses and that the losses accumulate beyond the margin requirement, your broker will initiate a margin call,  which is an instruction from the broker asking you, the investor, to add, money to your account to meet the margin requirement.

What happens if you don’t heed the call?

If you fail to heed the call, the broker is obligated to close your open positions so as to preserve the broker’s capital that was loaned to you as leverage.

Therefore, when thinking of how leverage relates to margin call, think of it in these terms, a margin call is issued by the broker to protect the leverage extended to you.

Conclusion

In this article, I have endeavoured to explain what leverage is and how you can use it to grow your trading account. A few take home points worth remembering

  1. Leverage is a double edge sword, handle it with care
  2. Low leverage is highly advisable because research has shown that investors who use low leverage of <5:1 have the highest winning percentage.
  3. Leverage is borrowed money that is charged interest by the broker. Don’t be too quick to take the high leverage offered by some brokers.
  4. The brokers will always protect their interests meaning that in case your trades are in losses beyond the margin requirement, the broker can issue a margin call.

So, don’t be in a hurry to blow your account by going for high leverage. Raise sufficient margin, then apply for moderate margin (which will be determined by your skill level and the calculations presented above). By so doing, you will increase the odds of surviving in the highly rewarding forex markets.