What Is Leverage In Forex Trading?
Leverage is the ratio between the amount invested by a trader and the credit provided by a broker, therefore leverage is a form of borrowed capital that allows a trader to increase their profit potential.
For example, should a trader have a $1000 trading account, a 1:100 leverage provided by a broker would allow them to trade a maximum of $100 000. Now the trader can open positions up to a value of $100 000 e.g. 1 standard lot of USDCAD could be traded, since the total margin required to open the position is $100 000.
Following is a table showing the total amount that can be traded with a $1000 deposit, using different levels of leverage.
So, a simple way to determine the total amount that you can trade with a certain leverage is:
Total amount= Equity x Leverage ratio
Total amount= $1000 x 100= $100 000 worth of positions
Another name for leveraged trading is margin trading, the reason being that a trader is expected to provide a certain % of total trade value to open and maintain positions, and the broker provides the rest of the required capital.
Let us clarify, what is margin? Margin is the $ amount that a trader provides to open and maintain a trade, but how does this relate to leverage?
Essentially, the leverage determines the margin requirement of the trader i.e. the % of the total value of the transaction that they must provide. Leverage can be described as a ratio of margin, for example, if a trader has a 1:100 leverage then for every $1 of margin they provide, the broker credits them $100. Here is a breakdown to avoid confusion.
To calculate how much margin you require to open a trade:
Margin= Total trade value x % margin required
Margin= $100 000 x 2%= $2000
Therefore, a margin of $2000 will be required for you to open a trade
To calculate leverage using margin:
Leverage= Trade value/ equity invested (margin)
Leverage= $100 000/ $500= 200
Therefore, leverage is 1:200
Actual Vs Margin Leverage
Now that we have discussed what leverage, margin, margin %, trade volume, and total trade value are as well as how they relate to one another, let us look at actual leverage vs margin leverage.
Margin leverage is the amount of leverage the broker provides per trade, to calculate the actual leverage that you are using at a given moment:
Actual leverage= Value of all trades/ Total equity
e.g. Actual leverage= $50 000/ $2500= 20
Therefore, the actual leverage would be 1:20, since you are trading 20 x your total capital.
Actual leverage changes based on the fluctuating value of your account and the total value of all the trades open. Margin based leverage is consistent and can only be changed with your broker.
How leverage applies to Forex trading?
Many beginner traders first trade Forex because of the high leverage compared to other financial instruments, let’s see why this is the case.
The price moves in Forex are rather small compared to other markets. Say that you buy EURUSD at 1.10 and close the position at 1.11, a good 100 pip profit, however, that move is only worth 1 cent.
Forex traders can only make substantial money by trading large volumes and leveraging that 1 cent move. Brokers understand that to make Forex an attractive option for retail traders, they need to provide greater leverage.
Advantages and disadvantages of leverage
You may have heard that leverage is a double-edged sword, this is true, it can help you and it can hurt you. Before you choose the highest leverage to achieve maximum profits, you also need to consider the risks that it can come with.
Greater profit potential– As already mentioned, the main advantage of leverage is that it allows a trader to enter larger positions, thus increasing the potential profit amount.
Increase the number of positions– Because leverage provides more capital, a trader can enter positions in different currencies, improving diversification.
Balances out low volatility environments– The small moves during involatile times can be mitigated with greater leverage. To understand more about volatility read our in depth article.
Can start with small investments- Leverage allows a trader to start with low capital amounts and build from there.
Greater risk- No coin is single-sided, it is far easier to open positions with volumes that are too large and wipe out your trading account.
Losses can exceed deposits- You have probably come across this warning at some point, what this means is that you can lose more than the capital that you deposit, and will be liable to pay any differences. By leveraging and opening a position, for example, 1000 times your equity this situation could occur.
Margin call risk- It is important to keep an eye on how much margin you have left in the account, if this drops below the $ amount required by a broker then they may close out positions.
These disadvantages can be mitigated by implementing proper risk management in your trading. Now lets discuss how to think about and use leverage correctly…
How to use leverage correctly?
Using leverage is the smart choice, especially for a new trader with little capital, as long as you still manage risk correctly. This involves using stops, considering risk to reward, and having a maximum risk amount.
Assuming you chose to risk a max of 2% per trade and you have the level where your stop loss should be, your position size should be determined by these two factors. By doing this, leverage can be used in the correct way because the % of your account that you are risking is limited.
What leverage is the best?
You may be sitting, tapping your foot, wondering when I am going to tell you which leverage amount is the best? Well, the most common ratio is 1:100, and I suggest that you do not go over this, but a good staring point for a beginner is a 1:10 ratio.
This ratio makes it easy to keep in mind how much margin you require (since you simply have to divide by 10). It will also provide you with the necessary added capital to trade effectively, and it prevents the excessive use of leverage (because if you need more then you are likely overtrading).
Hold on, this is a good general ratio, though before you make a decision here are some other guidelines: Longer-term traders will require less leverage than a scalper. Due to the fact that a long term trader will open fewer positions and will wait for bigger moves vs. a scalper who will open many trades and bank smaller pip moves, so more leverage might be needed. My point is to consider how you trade and whether more or less leverage is suited to the approach.
Another factor is the amount of capital that you are able to put into trading. $100 000 will require less leverage than a $1000 account because the borrowed capital from the broker is not needed to open or maintain positions.
Look at where you are in your journey and your approach to the markets, then you can make an informed decision about how much leverage you should use.
Also make sure that you chose a reputable broker who is regulated and honors your contractual agreements, so you only have to worry about managing your risk in the markets. Check out Plus500 who offer leveraged trading, a secure platform, and a number of other benefits over competitors.
We have reached the finish line. In this post, we discussed what leverage is, how it is used in forex trading, the pros and cons, how to use leverage correctly, and what ratio is best. If you are still confused, that’s ok, it is a difficult concept to grasp at first but give the article another read and you will be all the wiser. Also take your time in considering how much leverage is best for you.
Leverage can be a friend, don’t make it your enemy.
Risk disclosure – Trading CFD’s carries risk, losses can exceed deposits.
Plus500 is licensed by the FCA.