One reason why most people are attracted to forex rather than other financial instruments, is the ability to use high leverage. Although most traders may have heard about leverage, a few only understand it completely and know how to use it properly.
We will discuss the main concept of borrowing funds and will point out the advantages and disadvantages of leverage in forex. We will also tell you why you should see leverage as a double-edged sword.
How leverage is used in forex
Using leverage in forex trading is the act of borrowing funds from a broker or financial institution to be able to trade with larger volumes.
Brokers offer leverage in different ranges. Traders usually use this tool to multiply their profit from small differences in exchange rates. What they don’t know is that leverage could also multiply their potential loss from a certain trade.
Definition of leverage in forex
As mentioned above, using leverage means borrowing funds for investment in something. In forex, the fund is usually borrowed from the broker. High leverages are available in forex, meaning that there needs to be a margin to support the loan. Therefore trader will be able to take control of a large fund and start trading.
To calculate leverage based on margin, divide the actual value of your trade by the amount of margin:
Leverage = Total value of trade / Margin
For example, if you are required to deposit 1% of the actual value as a margin, while you intend to trade 1 lot USD/CHF, the required margin will be 1,000 U.S Dollars. Therefore the amount of leverage you are using will be 1:100. For depositing only 0.25% of the actual value, you will need to use 1:400 leverage.
However, the margin-based leverage doesn’t necessarily affect the amount of risk. The trader is always allowed to deposit more margin to support the trade. This shows that the actual leverage is the most powerful indicator of profit or loss, not the margin-based leverage.
To calculate the actual leverage that you are using right now, you could simply divide the total value of your positions by your trading capital:
Actual leverage = Value of Positions / Total Trading Capital
For example, if you have 10,000 U.S Dollars in your trading account and you open a position with one standard lot volume, which is 100,000 units, your actual leverage would be (100,000/10,000 = 10) ten. If you trade 2 lots with total value of 200,000 U.S Dollars, your actual leverage will be 2.
This means that the amount of margin-based leverage is the amount of actual leverage is able to use. Since traders don’t use their entire margin for just one trade, their actual margin tends to be different from the margin-based one.
Generally, traders are recommended not to use all their margin on one trade. A trader should use margin when there is a clear win.
When the amount of risk had been specified using pip, the amount of drawdown could be determined. As a rule of thumb, the amount of potential loss shouldn’t be more than 3% of you total trading capital. If the potential loss of a certain position reaches 30% of your total capital, the amount of leverage shall be reduced. Each traders has a certain level of experience and risk parameters, but they may sometimes make a mistake and expose a large a amount of their capital to risk.
Traders may also calculate the amount of margin they are allowed to use. Imagine you have 10,000 U.S Dollars in your trading account and you want to trade 10 micro-lots of USD/JPY currency pair. In this case each pip is equal to 1 U.S Dollar. Meanwhile if you trade 10 mini-lots, each pip is equal to 10 U.S Dollars, and if you trade 100 mini-lots, the value of each pip will be equal to 100 U.S Dollars.
A 30 pip stop loss could be an indicator of 30 U.S Dollar loss for 1 mini-lot. 300 U.S Dollars for 10 mini-lots and 3000 U.S Dollars for 100 mini-lots; therefore, you could leverage only up to 30 mini-lots, if you have 10,000 U.S Dollars in your trading account to expose only 3% of your capital to risk in each trade.
Leverage in forex
In the foreign currency market, leverage sometimes rises as high as 1:100. This means that you can trade 100,000 U.S Dollars, if you have 1,000 U.S Dollars in your account. Most traders believe that the reason why such high leverages are offered in forex is that leverage is a function of risk. They know that if they manage their account properly, they will be able to control the risk. In addition, since forex is the most liquid financial market, trades are executed in an instance, therefore controlling leveraged positions is so much easier.
The exchange rate variation in forex is measured in pip. These movements are in fact a percentage of the price variation. For example, when the exchange rate of a currency pair such as GBP/USD changes from 1.9500 to 1.9600, the total variation is 1 cent.
Therefore, currency trading shall be carried out in large volumes to be profitable. The most useful tool to accumulate the profit is leverage. When you trade with 100,000 U.S Dollars, even small changes could lead to significant profit or loss.
Risk of leverage
Here is why we call leverage a double-edged sword. Because actual leverage could multiply your loss or profit by the same factor. The larger leverage you choose, the greater risk you bear. Have in mind that this risk is not related to margin-based leverage, although it may influence the risk in case of carelessness.
Let’s explain this with an example. Both traders “A” and “B” have 10,000 U.S Dollars in their trading accounts, and they both trade in the same broker which requires them to deposit 1% margin. Both traders believe that USD/JPY has reached its high and is going to fall in a downtrend, therefore they both go short in 120.
Trader “A” chooses 1:50 as his/her actual leverage and goes short. Since each pip in the USD/JPY currency pair equals 8.30 U.S Dollars, one pip for 5 standard lots equals 41.50 U.S Dollars. If USD/JPY reaches 121, trader “A” will loose 100 pips, which is equal to 4,150 U.S Dollars. This loss is 41.5% of the trader’s total capital.
On the other hand, since trader “B” is a more precise trader, he/she chooses 1:5 as his/her actual leverage. Trader “B” also trades 50,000 U.S Dollars which is half standard lot in this case. If the exchange rate of USD/JPY reaches 121, trader “B” will only loose 100 pips which will be equal to 415 U.S Dollars. This amount is 4.15% of the trader’s total capital.
When you learned how to use leverage in forex, you don’t need to be afraid of it anymore. The only instant where you shouldn’t lever your position, is when you are not sure about the trading opportunity. Otherwise, leverage could win you significant money if managed properly. Like any other sharp tools, leverage also has to be used carefully.
Aron Groups Broker offers its clients up to 1:500 leverage. Therefore both novice traders and professional traders can choose from a wide range of offered leverages. Try to use leverage with caution and start low if you do not have enough experience.
Written by: Mohsen Mohseni (Aron Groups).