Leverage is a feature or offering by the Forex trading brokers to their customers which allows you to trade with borrowed money.
In simple words, by using leverage you can trade large amounts of money by using very little of your own money and borrowing the rest from the broker. Fully understanding leverage & its risks is important before you margin trade, especially if you are new to Forex trading. It is easier to get attracted to the potential of gaining big with low capital, but beware of the risks.
In this chapter, we will discuss what is leverage, and how to manage it in your trading strategy.
Forex trading generally requires a huge capital base to start trading. Small Retail investors cannot invest a huge sum of money initially when they start. That is where the concept of leverage helps you to enter the market with a margin amount.
This increases the investors’ capital base. So, Leverage in Forex trading indicates the borrowed capital in order to trade a bigger position with the limited invested capital. In other words, it is the excess money borrowed for trading than one usually holds in their account.
Leverage helps in trading bigger volumes and can amplify both profits and losses. Leveraged trading helps in investing in much larger amounts of trade, with a minimum deposit in your account.
Leveraged trading is also known as margin trading. One can open an account with the broker with a small amount and then borrow the rest of the amount from the broker to trade in a large position.
Let’s understand the concept with a small example.
Emmanuel opens an account with Broker B with US$1000 capital but wants to actually trade an asset that has a value of US$100,000. For this, Emmanuel borrows money from his/her broker. The margin here for Emmanuel is US$1000 and the rest of the money is borrowed from the broker.
The leverage here in the above example is 100:1. Emmanuel can now invest US$100,000, which is 100X his capital with only investing actual US$1000.
Generally, the borrowing of this fund is usually done from the broker through their online platform. The margin money, required as a stated ratio of a standard trade, has to be maintained with the broker as a security all the time. This is important especially in case of losses, when margin money is used to cover the losses.
In that case, the margin money should be deposited immediately to fill up the breach or the trade will be closed automatically by the broker. This helps to keep a check on the margin amount and thus reducing the chances of default risk to an extent.
Leverage can be easily calculated by dividing the Total Value of the trade that you want to place by the required margin amount. This is known as Margin-based leverage.
For example, for a standard trade transaction lot of US$100,000, if the required margin is defined as 1%, then margin amount or the capital invested would be US$1000. Hence, the leverage in this case would be:
Total Value of trade/Margin required = 100,000/1000 = 100:1
Similarly, if the margin requirement is only 0.25%, the leverage would now increase to 400:1, with margin requirement amount of US$250.
The amount of leverage a trader or an investor has would depend on the broker and the leverage ratio standard offerings vary from region to region, depending on the regulator. While European Security and Markets Authority (ESMA) has strict rules of leverage and has reduced the leverage quite a bit since the start, the Australian Securities and Investments Commission (ASIC), once a wider market for high leverage trades, has recently proposed to implement a leverage cap to protect the interests of retail investors.
As we now understand that leverage has an advantage to potentially increase your profits but it is righlty also called a two-way sword.
The leverage may give the investor extra funds to trade on but at the same time carries a risk of increased potential losses, that can exceed your trading balance if your broker does not offer negative balance protection.
Trading with high leverage means, both your profits & losses will be magnified. Higher the leverage is, the risk of potential losses also become high.
The relation of risk and leverage is directly proportional, that is if the leverage rises, the risk too rises with it.
For example, let us continue our case from above. In the first scenario, with a capital of US$1000 and a 100:1 leverage, suppose an investor enters a buy trade in EUR/USD at a certain price (say 1.1200). So you will be trading a position equivalent to $100,000 i.e. 1 Standard Lot.
Now, if the value of EUR/USD jumps up by 10 pips and the investor decides to close the trade, the investor earns a profit of US$100 on a standard trade lot of US$100,000. This would, in turn, earn the investor a 10% return on the invested capital of $1000.
Now, let us consider the second scenario with a capital of US$250 and leverage 400:1. Again, a jump of 10 pips on the trade of EUR/USD pair would give a US$100 profit, but this time the return on invested capital would jump up to 40%.
Hence higher leverage offerings by the brokers are the focal point of acquiring customers, as it gives the first-time investors or even seasoned retail investors the luxury to play around with lesser capital base.
However, not just profits, but even the losses are bigger in high leverage trades, and it may result in faster erosion of the margin money.
Now, let’s see an example of high losses due to high leverage. Let us continue with our above example with the opposite scenario. As per our first case, the invested capital is US$1000, which is also our margin amount.
Now, if instead of jumping up, the EUR/USD value falls by 10 pips, the investor would incur a loss of US$100 due to 100:1 leverage on a standard trade lot US$100,000. This US$100 loss is covered through the margin amount of US$1000, and the margin amount deposited with the broker now falls to US$900 and the broker will issue a margin call (based on the margin requirements of their trading account) to replenish the margin by $100. This would result in the loss of 10% on the invested capital.
If we turn to the second scenario, a fall of 10 pips in EUR/USD value would again mean a loss of US$100 for the investor. But this time since the margin money is US$250 and leverage is higher i.e. 400:1, it would be a loss of 40% on the invested capital, reducing the deposited margin amount to US$150.
According to publicly listed statistics at most regulated brokers, almost as high as 70-80% retail forex & CFD traders lose.
So, you should understand that your risk of losing our entire trading capital in just a few trades is even higher if you are using too much leverage.
Professional traders usually choose very low leverage ratios, not using more than 10:1 for safety.
This would seem contradicting, considering that professional traders are into trading to earn maximum profits. But professional traders generally follow the rule of not getting lured by high leverages as a means of good money management.
Remember risk to reward: Low leverage would require higher margins, which would restrain professional traders from investing huge amounts of capital. Besides this, professional traders also follow the method of risk-to-reward ratio, which again keeps them from trading with large positions. In order to follow this ratio, they have to keep a limit to their losses up to a maximum position which helps them manage their risks.
Leverage in Forex trading plays an important role in deciding your risk levels and should not be the foremost criteria to start trading.