Forex Leverage is important in online currency trading; the meaning of the keyword Leverage is borrowing a certain amount of the money needed to trade something. Prudent International Ltd team made this article about Leverage Forex to know more about Leverage Forex definition.
In the case of Forex, that money is usually borrowed from a Forex broker.
Forex trading brokers does offer high leverage in the sense that for an initial margin requirement, a trader can build up – and control – a huge amount of money.
The concept of leverage is used by both Traders and brokers. Traders use leverage to significantly increase the returns that can be provided on an investment.
They lever their investments by using various instruments that include options, futures and margin accounts.
Companies can use leverage to finance their assets. In other words, instead of issuing stock to raise capital, companies can use debt financing to invest in business operations in an attempt to increase shareholder value.
In Forex, traders use leverage to profit from the fluctuations in exchange rates between two different countries. The leverage that is achievable in the Forex market is one of the highest that investors can obtain.
Forex leverage is a loan that is provided to an trader by the broker that is handling his or her account. When an investor decides to invest in the Forex market, he or she must first open up a margin account with a broker. Usually, the amount of leverage provided is either 50:1, 100:1 or 200:1, depending on the broker and the size of the position the investor is trading.
Standard trading is done on 100,000 units of currency, so for a trade of this size, the leverage provided is usually 50:1 or 100:1. Leverage of 200:1 is usually used for positions of $50,000 or less.
To trade $100,000 of currency, with a margin of 1%, an trader will only have to deposit $1,000 into his or her margin account.
The leverage provided on a trade like this is 100:1. Leverage of this size is significantly larger than the 2:1 leverage commonly provided on equities and the 15:1 leverage provided by the futures market.
Although 100:1 leverage Forex may seem extremely risky, the risk is significantly less when you consider that currency prices usually change by less than 1% during intraday trading.
If currencies fluctuated as much as equities, brokers would not be able to provide as much leverage.
Although the ability to earn significant profits by using leverage is substantial, Forex leverage can also work against investors. For example, if the currency underlying one of your trades moves in the opposite direction of what you believed would happen, leverage will greatly amplify the potential losses.
To avoid such a catastrophe, Forex traders usually implement a strict trading style that includes the use of stop and limit orders.
Forex Leverage Example
For example, if you are required to deposit 1% of the total transaction value as margin and you intend to trade one standard lot of USD/CHF, which is equivalent to US$100,000, the margin required would be US$1,000.
Thus, your margin-based leverage will be 100:1 (100,000/1,000). For a margin requirement of just 0.25%, the margin-based leverage will be 400:1, using the same formula.
However, margin-based leverage does not necessarily affect one’s risks. Whether a trader is required to put up 1 or 2% of the transaction value as margin may not influence his or her profits or losses.
This is because the investor can always attribute more than the required margin for any position. What you need to look at is the real leverage, not margin-based leverage.
For example, if you have $10,000 in your account, and you open a $100,000 position (which is equivalent to one standard lot), you will be trading with a 10 times leverage on your account (100,000/10,000).
If you trade two standard lots, which is worth $200,000 in face value with $10,000 in your account, then your leverage on the account is 20 times (200,000/10,000).
This also means that the margin-based leverage is equal to the maximum real leverage a trader can use.
And since most traders do not use their entire accounts as margin for each of their trades, their real leverage tends to differ from their margin-based leverage.
Leverage in Forex Trading
In currency trading, we monitor the currency movements in pips, which is the smallest change in currency price, and that could be in the second or fourth decimal place of a price, depending on the currency pair.
However, these movements are really just fractions of a cent. For example, when a currency pair like the GBP/USD moves 100 pips from 1.9500 to 1.9600, that is just a one cent move of the exchange rate.
This is why currency transactions must be carried out in big amounts, allowing these minute price movements to be translated into decent profits when magnified through the use of Forex leverage.
When you deal with a large amount like $100,000, small changes in the price of the currency can result in significant profits or losses.
When trading FX, you are given the freedom and flexibility to select your real leverage amount based on your trading style, personality and money management preferences.
Risk of High Leverage For Beginners
Real leverage Forex has the potential to enlarge your profits or losses by the same magnitude. The greater the amount of leverage on capital you apply, the higher the risk that you will assume.
Note that this risk is not necessarily related to margin-based leverage although it can influence if a trader is not careful.
Both Trader A and Trader B have a trading capital of US$10,000, and they trade with a broker that requires a 1% margin deposit.
After doing some analysis, both of them agree that USD/JPY is hitting a top and should fall in value. Therefore, both of them short the USD/JPY at 120.
Trader A chooses to apply 50 times real leverage on this trade by shorting US$500,000 worth of USD/JPY (50 x $10,000) based on his $10,000 trading capital.
Because USD/JPY stands at 120, one pip of USD/JPY for one standard lot is worth approximately US$8.30, so one pip of USD/JPY for five standard lots is worth approximately US$41.50.
If USD/JPY rises to 121, Trader A will lose 100 pips on this trade, which is equivalent to a loss of US$4,150. This single loss will represent a whopping 41.5% of his total trading capital.
Trader B is a more careful trader and decides to apply five times real leverage on this trade by shorting US$50,000 worth of USD/JPY (5 x $10,000) based on his $10,000 trading capital.
That $50,000 worth of USD/JPY equals to just one-half of one standard lot. If USD/JPY rises to 121, Trader B will lose 100 pips on this trade, which is equivalent to a loss of $415. This single loss represents 4.15% of his total trading capital.
With a smaller amount of real leverage applied on each trade, you can afford to give your trade more breathing room by setting a wider but reasonable stop and avoiding risking too much of your money.
A highly leveraged trade can quickly deplete your trading account if it goes against you, as you will rack up greater losses due to bigger lot sizes.
Keep in mind that leverage is totally flexible and customizable to each trader’s needs.
Having an aim of trading profitably is not about making your millions by the end of this month or this year.