When compared to trading stocks or other financial products, the leverage that traders can use when trading foreign exchange is often much higher. The term “leverage” is familiar to many traders, but few understand what it means, how it operates, or how it can affect their bottom line. The Foreign Exchange (Forex) markets are another place where the idea of “using other people’s money to join a transaction” can be used. Visit multibank group
This post will talk about the pros and cons of trading with borrowed money, as well as how to use leverage in your forex trading strategy.
A Definition of Leverage
The term “leverage” refers to the practice of borrowing a portion of the capital required to make an investment. It is common practice to borrow funds from a broker when trading foreign exchange. Forex trading has high leverage, which means that a trader can build up a large amount of money and control it with a small initial margin.
Margin-based leverage is determined by dividing the total value of the transaction by the required margin:
Margin-based leverage is calculated by dividing the total value of a transaction by the margin that is needed.
So, if you need to put down 1% of the value of your transaction as margin and you want to trade one standard lot of USD/CHF, which is worth $100,000, you’ll need to put down $1,000. As a result, the ratio of your margin to your initial deposit will be 100:1. Using the same calculation, the margin-based leverage will be 400:1 with a margin requirement of just 0.25%.
A trader’s potential profit or loss might not change if they must put up 1% or 2% of the value of the transaction as margin, because risk is not always proportional to the amount of margin used. This is because the margin requirement for any given position will never be met if the investor attributes a larger amount. This suggests that real leverage in forex trading, not leverage based on margin, is a better way to measure whether you are doing well financially.
To find your effective leverage, divide the total market value of all your open positions by the amount of trading capital you have on hand:
To calculate actual leverage, divide the value of the trade by the value of the trading capital.
If you have $10,000 in your account and you open a $100,000 position (equal to one standard lot), you will be trading with 10 times the leverage on your account (100,000/10,000). If you have $10,000 in your fx trading account and buy two standard lots (worth $200,000), your leverage is 20 times ($200,000/$10,000).
This means that a trader can use the same amount of leverage as they have in their margin account. The real leverage of most traders differs from their margin-based leverage because they do not use their whole accounts as margin for each deal.
A trader should not, in most cases, trade with all their available margin. Leverage is a powerful tool, but a trader should only use it when the odds are overwhelmingly in their favour.
Capital loss can be estimated after the amount of risk, in terms of pips, is known. This kind of loss should never account for more than 3 percent of your total trading capital. When the risk of loss for a position is more than a certain percentage of trading capital, say 30%, the amount of leverage used in that position should be decreased. When deciding whether to stick to the recommended risk limit of 3%, traders should use their own judgment.
Margin requirements can be determined by traders as well. Let’s say you’ve got $10,000 in your forex trading account and you want to buy 10 mini lots of USD/JPY. When trading with a single mini account, a one-pip change is worth about $1, but when trading with 10 minis, the same change is worth about $10. One hundred dollars’ worth of profit or loss for every one pip in a trade involving one hundred minis.
Therefore, if you trade mini lots, a stop-loss of 30 pips may mean a loss of $30 for one mini lot, $300 for ten mini lots, and $3,000 for a hundred mini lots. You should only leverage up to 30 mini lots, even though you may be able to trade more with a $10,000 account and a 3% maximum risk per deal.
Forex Trading Leverage
Maximum leverage of 100 to 1 is frequent in the forex markets. This equates to a $100,000 trading cap for every $1,000 in your account. Many investors believe that the high levels of leverage offered by forex market makers are a direct result of the market’s inherent risk. They wouldn’t let you borrow money if they didn’t think the risk could be kept within a reasonable range if the account was managed well. On the spot cash currency markets, it is also much easier to start a deal and end it at the price you want than on other, less liquid markets.
The smallest increment by which a currency’s value might fluctuate is known as a “pip,” and it is measured in pips when trading. These changes are negligible, amounting to just a few cents. As an illustration, consider a hypothetical 100-pip (or 1-cent) fluctuation in the exchange rate between the British pound and the United States dollar.
Because of this, large-scale currency transactions are needed so that even small changes in price can lead to big profits by being multiplied many times over. When dealing with a large sum, like $100,000, even a slight change in the exchange rate can have a profound effect on earnings or losses.
The Danger of High Real Leverage in Forex Trading
Real leverage in forex trading can make your gains or losses the same amount bigger, so be careful how you use it. If you use a high ratio of borrowed funds to your own equity, you’ll be taking on a correspondingly larger level of risk. Please be aware that this risk is not directly tied to margin-based leverage, though it can be influenced by it if a trader is careless.
We can better understand this if we look at an example. Traders A and B both use a broker that demands a 1% margin deposit and have a trading capital of US$10,000. Both parties have done the math and conclude that the USD/JPY has reached its peak and is about to decline. So, they both sell US dollars for Japanese yen at 120.
Trader A decides to short US$500,000 in USD/JPY (50 x $10,000) with only $10,000 in trading capital. At the current USD/JPY exchange rate of 120, one pip of USD/JPY is worth around US$8.30 for one standard lot and about US$41.50 for five standard lots. Trader A will incur a loss of 100 pips ($4,150) if the USD/JPY exchange rate increases to 121. Their entire trading capital will be reduced by 41.5% due to this one loss.
Trader B, who is more cautious, decides to short US$50,000 worth of USD/JPY (five times real leverage) using their initial trading capital of $10,000. Half of a normal lot is equal to $50,000, so that’s not a lot at all. Trader B stands to lose $415 (or 100 pips) if the USD/JPY exchange rate increases to 121. This one setback has cost them 4.15 percent of their total trading capital.
Once you understand how to use it properly, leverage should not strike fear into your heart. If you plan on being completely hands-off with your trading, you should never use leverage. In any case, if leverage is managed well, it can be used to great advantage. Leverage is a sharp tool in forex broker trading, and like any other tool, it needs to be handled with care.
When using less real leverage per trade, you have more freedom to maneuver by placing a wider but still appropriate stop and protecting your cash from a larger loss. If the deal goes against you and the leverage is high, you could quickly run out of money in your trading account because the bigger lot sizes mean bigger losses. Remember that leverage can be adjusted to meet the demands of every individual trader.