There are many reasons why lots of people are interested in trading forex. One of these reasons is that, when compared with other financial instruments like stocks, trading forex gets much higher leverage than for different classes of instruments.
"Leverage" is a term frequently heard in trading, yet many don't know its meaning or who it works, nor do they know how it can impact directly on their bottom line.
Using money belonging to others for a transaction can happen in forex markets. This article will explore the many benefits of using other people’s money (borrowed capital) to trade and will examine why using leverage in forex trading could be a wolf in sheep’s clothing.
- Leverage means using borrowed capital to increase your trading position above what you would be able to do from your cash balance.
- A brokerage account allows you to employ leverage via margin trading with the broker providing borrowed funds.
- Traders in forex will often employ leverage to profit from small price changes in pairs of currencies.
- With leverage, though, you might end up amplifying losses as well as profits.
Leverage means borrowing a set sum of money that you need to invest in something. For forex, a broker most often provides these funds. There is high leverage offered in forex trading since, for an initial market need, a trader can build up – and be in control of – a considerable sum of money.
To work out margin-based leverage, you have to divide the total value of the transaction by the sum of margin that you have to put up:
Margin-based leverage = total transaction value / required margin
Let's look at an example. If you have to deposit one percent of the total value of the transaction as margin and you want to trade one lot of USD/CHF (the equivalent of 100,000USD, the margin you would need is 1000USD. Therefore, the margin-based leverage is 100,000/1,000, which is 100:1. If you have a margin requirement of 0.25 percent, the same formula will calculate your margin-based leverage to be 400:1.
Here are some other figures:
|Margin required for a total value of the transaction||The ratio of margin-based leverage|
Margin-based leverage, however, does not always affect your risk. A trader who is required to raise 1% or 2% of the value of the transaction as the margin might not see an influence on their losses or profits. Since an investor can attribute more than is required for the margin, the impact won't always happen. This shows that margin-based leverage is a weaker indicator of loss and profit in comparison with real leverage.
If you want to work out the real leverage that you are employing, you need to divide the total face value of your open positions by the trading capital:
Real Leverage = Transaction Value Total / Total Trading Capital
Let’s look at an example. If your account holds 10,000USH and you open one standard lot (100,000USD), you are trading with leverage ten times on your account (100,000 / 10,000).
If you trade 200,000USD in face value (two standard lots) with the only 10,000USD in your account, then your account leverage is 200,000/10,000, which is twenty times.
This also signifies that the maximum real leverage a trader can use is equal to the margin-based leverage. As most forex traders don't use their full account as margin for their trades, their actual real leverage differs from the margin-based leverage they have.
In general, it is not advised to use all of the margin available. Leverage should only be used when there is a definite advantage on their side.
If a trader knows how many pips there are and thus, the amount of risk, they can then determine how much capital they could potentially lose. Generally speaking, traders should never lose more than three percent of their trading capital. If leverage is at a point where losses could be 30%, for example, then there should be a reduction in leverage to compensate. Traders will, of course, have their risk parameters and experience and do decide to deviate from the suggested guideline amount.
Traders also calculate their level of margin. For example, a trader has 10,000USD in their trading account, and they want to trade ten mini USD/JPY lots. Every move of a pip is worth around 1USD in a mini account but, when a trader trades ten minis, every pip move has a value of around 10USD. If a trader trades 100 minis, every pip move is then worth around 100USD.
A 30-pip stop-loss, therefore, could represent a loss potential of 30USD for a single mini lot, 300USD for ten mini lots, or 3000USD for one hundred mini lots. Thus, with an account of 10,000USD and a risk maximum of 3% per trade, a trader should only leverage up to thirty mini lots despite possibly having the capability of trading more.
Forex Trading with Leverage
Commonly, in forex markets, leverage is as high as 100:1. This means, therefore, that each 1000USD in an account can be traded up to a value of 100,000USD. Lots of traders say that forex trades are so high in terms of leverage because the leverage here is a function of risk. With a properly managed account, any risk is very manageable. Otherwise, there wouldn't be such high leverage. Besides, due to the spot cash foreign exchange markets being so liquid and large, there is a high ability to enter and exit trades at the desired level. It is much easier to do this than in less liquid markets.
When trading, the currency movements are monitored in pips. This is the smallest change in the price of the currency, and it does depend on the currency pair. Put, a pip is just a fraction of a cent. By way of example, when a currency pair like GBP/USD moves by 100 pips to 1.9600 from 1.9500, that is a movement of one cent of the exchange rate.
For this reason, currency trading is carried out in large amounts. A tiny movement in price will make a more significant difference in profits by using leverage. When you are dealing with large sums like 100,000USD, small price changes will result in substantial losses or gains.
Excessive Real Leverage Risks when Trading Forex
This is where our title of 'wolf in sheep's clothing' comes in. Real leverage can enlarge a trader's profits or their losses by the same magnitude. The higher the leverage on your capital, the higher your risk. This risk isn't, however, related necessarily to margin-based leverage, but it can influence it if traders aren't careful.
Let's say two traders have 10,000USD trading capital, and they both trade with a broker that asks for a 1% deposit. They both agree that USD/JPY is high and predict a fall in value. They both, therefore, short the USD/JPY at 120.
One trader applies 50 times real leverage by shorting 500,000USD at 120 (one pip of USD/JPY for one standard lot is around 8.30USD. Thus, five standard lots make it work 41.50USD). Let's say USD/JPY rises to 121, and the trade will lose one hundred pips – equivalent to 4,150USD, a total representative loss of 41.5% of the total trading capital.
The second trader, on the other hand, decides to apply 5x real leverage by shorting 50,000USD worth of USD/JPY (5 times 10,000USD). This equates to half of one standard lot. Therefore, when USD/JPY goes to 121, this trade will still lose 100 pips on the trade, but their loss is the only 415USD, which is 4.15 percent of the trading capital total.
Once you've learned how to manage leverage, the fear of it will dissipate. The only time you should never use leverage is if you're hands-off with your trades. Leverage is used profitably and successfully by many traders with proper management. This is something that does need to be handled carefully, but once you understand it, you won't have any reason to worry.