Leverage means the big amount of money borrowed (loan) from the broker to buy a highly valuable asset with your small investment fund.
The foreign exchange (also known as Forex, FX) market was specifically created for trading different currencies worldwide. It also determines the currency exchange rate worldwide. It generally has to do with the buying and selling of currencies at given prices.
Followed by the credit market, The Forex market is by far the largest in the world in terms of the trading volume.
It is well recognized and organized, as it works through various financial institutions. And also operates on different levels.
Just so you know, banks majorly rely on the behind-the-scene FX market for progress, as they turn into smaller financial firms regularly known as “dealers” and get involved in large positions.
The behind-the-scene market is often called the “interbank market” because banks are the major FX dealers. However, the FX market isn’t only for banks because other financial firms and insurance companies also trade in it.
The trade size amongst various foreign dealers can be very large, as it involves hundreds of millions of dollars, because of the sovereignty issues when involving two different currencies and Also because the market has little or no supervisory entity that regulates its actions.
Now, the Forex market is not limited to banks, insurance companies, and big financial firms only, as individuals, traders also can get into it and trade with little or no money with them, and this brings us to leverage trading. But what is forex leverage?
In this article, we shall look at what is leverage in forex and how traders can use it.
What is leverage in Forex?
Okay, before I go on to explain what is leverage in Forex, I would like to first explain the meaning of “Leverage.” Leverage simply means the use of borrowed capital to invest and expecting a bigger and greater yield compared to the payable interest.
Leverage is when an investor borrows money from a broker and trade with it, by trading a larger position in a currency.
On a clearer note, leverage magnifies the return from favourable movements. But other than magnifying profits, Leverage can also magnify losses.
To mitigate losses when trading, it is very important for traders to understand the concept of leverage trading in forex, and also learn how to manage leverage, by employing some risk management strategies.
How does leverage work in forex?
When comparing to other markets like stocks,bonds, ETF’s, the leverage in forex is higher and it works well due to high liquidity.
Being a very large market, there is over $5 to $8 trillion worth of currency exchanges that occurs daily. And forex trade has to do with buying and selling the exchange rates of currencies, with the aim that the rate will move in the direction that favors the trader.
The forex currency rates appear or are shown as bid and ask prices. So, if the trader decides to go long or buy a currency, they would be shown the asking price, and when they want to sell the currency, they would be shown the bid price.
For example, he/she can decide to buy the euro versus the U.S. dollar (EUR/USD), with the belief that the rate of the currency pair will rise. The trader would buy the EUR/USD at the asking price of $1.10. With the hope that the rate will move to his favor as planned, the trader will then unwind the position a few hours later by selling the same amount of EUR/USD back to the broker using the bid price.
So, basically, leverage is a loan provided by a broker to a trader. The forex account created by a trader is established to allow trading on margin or borrowed funds.
And many traders tend to tailor the amount of trade based on the leverage that they desire.
Normally, a percentage of the trade’s notional amount is required to be held in the account as cash, referred to as the initial margin.
Types of Forex Leverage Ratios
The Initial margin required from traders can vary, depending on the size of the trade.
For example, if a trader buys $100,000 worth of EUR/USD, the margin required to be held in the account might be $1,000. So if you get what I am explaining clearly, it means that 1% is $1,000 of $100,000 might be required.
A leverage ratio shows the magnification of a trade size through the result of the margin held by the broker. Now let’s use the example I have given above, the ratio of a $100,000 trade will equal 100:1 ($100,000 / $1,000). So, for a deposit of $1,000, a trader can trade $100,000 in a given currency pair.
Below, I have listed the examples of margin requirements as well as the corresponding leverage.
Equivalent leverage ratios as a result of the margin requirement.
As seen in the table above, the lower the margin requirements, the greater the amount of leverage that can be used on each trade. At times a higher margin might be required. It all depends on the currency that is being traded.
For example, the rate for the British pound versus the Japanese Yen can fluctuate greatly, thereby leading to a large swing in the rate. So, a broker may want more amount of money to be held as collateral (i.e. 5%) for more volatile currency pairs and during volatile periods.
How to calculate leverage in forex trading
One of the most important things in forex (FX) trading is calculating leverage. The reason is that the ability of a trader to trade on high leverage is a key difference between FX trading and other kinds of trading like stocks.
Leverage in forex trading is also one of the reasons why a lot of traders lose their money while trading forex.
Unlike in stocks trading where you only use two times your investment technically called 2 to 1. In forex trading, you can use up to 500 times (500 to 1) your investment, depending on your type of account or the country you are trading from.
Here is an example of how you can leverage on forex if you have $1000 and you want to trade Euro against Dollar (meaning Euro is the base currency)
Let’s say you first buy euro (EUR/USD) at 1.25
Let’s assume you anticipates that there will be a bullish (upward) trend.
If you fail to carefully analyze all points, or you are simply unlucky. The market will price movements will be against you.
In our case, lets us say the Euro drops by a few Pips and the rate gets to 1.20. At this moment, if you choose to get out of the market, this is what will happen:
You sell Euro at EUR/USD = 1.20, meaning you will make a loss of 0.05.
With the example given above, I believe you have seen that forex leverage can greatly amplify gains, and you can also lose money when you are unlucky. Many forex traders and investors often use leverage to make money from relatively small price changes in currency pairs.
Benefits of using leverage
Here are some benefits of leverage in forex:
Leverage provides traders the opportunity to trade with low capital. Before the existence of leverage in forex, only the rich and wealthy people who invest with larger capital were able to benefit, thereby making a huge return. But it is a different case with leverage. With leverage, the poor can now make huge returns, since it provides you with more capital to start trading in forex.
- Leverage has no interest percentage:
Contrary to getting a loan from a financial institution like a bank or shylock, leverage in forex does not incur any interest. This enables people who want to trade to get a loan with less fear because you are not expected to pay back any interest.
Introducing leverage to your forex trading increases the returns you make. For example, if you have $100, you can trade with up to $10,000 and more with the assistance of leveraging. Trading with leverage increases the profits you make.
Does forex leverage have any risks?
Of course, using leverage in forex has its own risks.
Using high leverage, you can risk less or more anytime depend on your wish. If you take high risk, you can expect high reward. for low risk, you can expect low reward.
First decide yourself whether you want to risk high or less in the forex market. Agressive trader always takes high risk, as he is ready to accept big losses in short time. While the conservative or secure trader always trade safe at any market conditions. Decide yourself how you want to trade on your account before placing the new trade from now.
Although you get to have a significant ability to earn more money with forex leverage, it is not always rosy, as it is a two-edged sword. By being two-edged sword it means that it can either help you make more money or result in larger losses.
For example, if a given currency trade goes against the direction you predicted, leverage will amplify losses i.e. you will lose money. In most cases, if this happens and the account balance is not sufficient to allow the trade to remain open until the trend changes, your account will get a margin call which could result to the loss of your trading capital.
You can avoid the risk of getting a margin call it is always good to keep the trade size small. And the way to do this is by using the smallest possible lot sizes when placing your trades.
You can also implement a strict trading strategy that incorporates the use of stop-loss. Implementing the stop-loss option will help control losses in forex trading.
Now, some persons might be curious about what the stop-loss is really about. A stop-loss is a kind of order in forex trading that the broker sets to help exit a trade position at a certain price level.
With the stop-loss order, a trader can cap losses on a trade.
How to use forex leverage as a trader
Using Leverage is like walking on the rope balancing the double edged sword.
Although many traders request for the largest trading leverage they can get on the forex trading platforms, professional forex traders doing margin-based trading prefer to trade with low leverage. The simple reason for trading with low leverage is to protect your trading capital in case of a wrong speculation during trading. It keeps the returns consistent.
If you ask a professional trader what trading leverage they use, they will probably tell you that it is either 10:1 or 20:1. And the reason is that it is possible to trade with that type of leverage not minding much about losses in case the market moves against any opened trading position.
Even if you must, you should maintain a low leverage level. You have to always stay cautious as staying cautious will make you enjoy a smooth and long ride in trading forex.
How to choose a leverage level:
To leverage forex, ensure to choose a leverage ratio that you are most comfortable with. For traders who are scared of taking risks or are new to the game and still learning how to trade in forex, the appropriate leverage for you is a lower leverage level like 5:1 or 10:1.
Different brokers, however, offer different leverage levels for different trading accounts. Therefore, you will require to choose the account wisely.
As a forex trader, the deposits you make in your account largely determine the forex trading leverage in your margin trading.
How to manage risk in forex
- Choose a good forex broker. There are many forex brokers offering different terms.
- Choose a broker who abides with the regulation (s) in your area
- Choose the right trading account
- Get a trading capital without overstretching you financial capability.
- You should build a good trading strategy
- Carefully choose the financial instrument (s) to trade
- Get a grasp on margin-based and leveraged trading.
- Remember leverage is a double-edged sword
- Set up a risk-reward ratio
- Make sure to risk management tactics like using stops and limits.
- You must not be too emotional when opening trading positions
- Always get updates on recent news and events. You should use your browsing experience to search for news from sites like investopedia.
- First, start with a demo forex trading account.
- Use the smallest possible lot sizes when opening positions/trades in order to keep the trade size small
Having completely explained what leverage is all about in forex trading, I would love to tell you to keep calm, as there is no need of being afraid. All you should do is carefully read this article, and follow the guideline on how to manage leverage in forex.
Remember that as a forex trader, you should never use leverage if you take a hands-off approach to your trades. With proper leverage management, you can use leverage successfully and comfortably in forex trading.
Once you master the concept of careful leverage management in forex trading then you are good to go and set to stay in the forex business for a long time.
When you apply a small amount of leverage level to trades, you get to set a wider and reasonable stop, thereby avoiding higher loss of capital.
Knowing that leverage can amplify profits; also know that a highly leveraged trade can greatly deplete your trading account if the trade does not move in your predicted direction, as you will incur a great loss due to the high leverage level of your trade.