Leverage in Forex is a tool that allows traders to control a larger position than the amount of funds they initially deposit. By using capital “borrowed” from a broker, traders can amplify their buying power.
In essence, leverage enables traders to handle significantly larger volumes of currency than the amount of their own invested capital, with the additional funds provided by the broker. This can grant access to trading opportunities that might otherwise be unattainable due to financial constraints.
When the position is closed, the borrowed money is returned to the broker, and the trader either profits from the gains or is responsible for covering any losses.
To initiate and sustain a leveraged trade, a trader must deposit a portion of the total value of the trade, known as the margin. This margin acts as collateral for the borrowed funds.
In Forex trading, leverage is typically expressed as a ratio, indicating the extent to which a trader can increase their market exposure relative to the margin. For example, a leverage ratio of 100:1 means that for every dollar of margin deposited, a trader can control $100 in currency value.
Interpretation of Leverage
For instance, a trading account with a leverage ratio of 1:30 means that a trader can open a position that is 30 times the size of their margin deposit. The collateral effect of this leverage is that any profits or losses will also be subject to the same 30-fold multiplication. This magnifies both potential gains and risks, making it crucial for traders to manage their positions carefully.
This means that if a trader invests $1,000 of their own capital with a 1:30 leverage, they can control a $30,000 position in the forex market. If the position moves favorably by just 1%, the trader gains $300, effectively a 30% return on their initial investment. Conversely, a 1% move against the trader would result in a 30% loss, potentially wiping out their margin deposit.
Thus, while leverage can increase a trader’s buying power and potential returns, it also raises the stakes significantly.
Calculating Retained Margin
The retained margin is calculated by dividing the nominal value of the contract by the leverage factor. The formula is:
Retained Margin = Nominal Value of the Contract / Leverage
Example of Margin Calculation for EUR/USD
Suppose you want to trade one lot of EUR/USD, whose nominal value is 100,000 EUR. Here’s how to calculate the retained margin for different levels of leverage:
- Leverage 1:500 – Retained Margin: 100,000 EUR / 500 = 200 EUR
- Leverage 1:200 – Retained Margin: 100,000 EUR / 200 = 500 EUR
- Leverage 1:30 – Retained Margin: 100,000 EUR / 30 = 3,333.33 EUR
Implications of Margin in Trading
Using leverage allows you to:
- Open a greater number of trades.
- Increase the nominal value of your trades, which can amplify both gains and losses.
Practical Example
If you decide to invest in a 100,000 EUR contract and your leverage level is 1:20, the required margin would be:
Required Margin = 100,000 EUR / 20 = 5,000 EUR
If your trading account balance is 15,000 EUR, you will have 10,000 EUR of free margin to open more trades. Additionally, this level of leverage allows you to control an investment of 100,000 EUR, so your profits or losses will be calculated based on this nominal value.
Calculating Profits or Losses
Profit or Loss = (selling price – buying price) × nominal value
Risks of Leveraged Trading
Trading with leverage is a double-edged sword. While it increases the potential for higher returns, it also increases the risk of significant losses, especially if the market moves against your position. High leverage can quickly lead to a “stop out” situation, where the broker closes your open positions if the capital falls below the required margin.
It is crucial to practice good risk management, especially when trading with leveraged instruments. This includes setting stop loss orders to limit potential losses and continuously monitoring open positions and market conditions.
Example of Leverage in Forex
In this example, we want to buy 3 lots of EUR/USD (nominal value of 1 lot = 100,000 euros).
We will not consider any costs for our example:
- Buy Price: 1.10500
- Sell Price: 1.10775
- Increase in pips: 27.5
- Trading Account Balance: 15,000 EUR
- Number of Contracts Bought: 3
- Leverage: 1:50
- Nominal Value of Investment: 3 x 100,000 = 300,000 EUR
- Margin Required for 1 Lot with 1:50 Leverage: 100,000 / 50 = 2,000 EUR
- Margin Required for 3 Lots: 3 x 2,000 = 6,000 EUR
- Pip Value: 10 USD, so opening 3 lots earns you 30 USD per pip
- Profit: 27.5 x 30 = 825 USD
- Return: Approx. 5.5%
The same would apply in case of losses.
Instruments That Can Be Leveraged
- CFDs (Contracts for Difference): These are agreements to exchange the difference in the price of an asset from when the position is opened to when it is closed.
- Forex (Foreign Exchange): Trading currencies with the potential to manage large positions with a relatively small amount of capital.
- Options: Financial derivatives that provide the right, but not the obligation, to buy or sell an asset at a set price before a certain date.
- Futures: Agreements to buy or sell an asset at a future date for a price that is agreed upon today.
- Forwards: Custom contracts to buy or sell an asset at a future date, similar to futures but not traded on an exchange.
- Warrants: Derivatives that give the right to buy the underlying stock of the issuing company at a fixed price until the expiry date.
Is it possible to invest in stock market shares with leverage?
Yes, it is possible! With CFDs on stocks, you can invest more money in the stock market than you have in your online trading account.
The Most Leveraged Markets
The Forex market is the most leveraged, followed by indices, commodities, and then stocks and cryptocurrencies.
Is Using Leverage in Forex Essential?
The necessity to use leverage in Forex depends on the amount of capital you have deposited:
- It may be necessary to use leverage if:
- You have a small capital to invest.
- You want to invest more than your capital.
- You seek more rapid volatility in less volatile markets.
- You can and want to take on more risks in your investments.
- You want to trade in markets like Forex where large nominal values or high volumes are required.
- It is not essential to use leverage if:
- You have a large initial capital.
- You have a significant risk aversion.
- You do not wish to invest in markets that require large volumes for trading.
Trading without Leverage
Is it possible to trade without leverage? Yes, absolutely. When you have all the money for the size of your position, the leverage is 1, meaning you do not borrow money to trade in the financial markets.
The need to have a substantial amount in the trading account is the major downside of trading without leverage. However, trading without leverage gives you lower risk exposure.
Nevertheless, this does not mean there are no risks involved, as the market can sometimes be unpredictable.
How Trading Works with vs. without Leverage
Let’s say a trader who has access to a leverage of 1:20 wants to buy €100,000 of EUR/USD, or one lot.
To calculate the required margin to open a position, you need to divide the total value of the position by the leverage factor. Therefore, in the above example, the required margin is €5,000 (i.e., €100,000 / 20).
Our trader has made a deposit of €5,000 to gain exposure to a position worth €100,000. The following table demonstrates the effect that this leverage has on our trader’s potential returns compared to an unleveraged position of the same size.
| Trading with Leverage | Trading without Leverage |
|---|---|
| Leverage Ratio: 1:20 | N/A |
| Investment: €5,000 | €5,000 |
| Exposure: €100,000 | €5,000 |
| EURUSD increases by 5%: +€5,000 | +€250 |
| EURUSD decreases by 5%: -€5,000 | -€250 |
As can be seen, the effect of leverage is to magnify the trader’s potential returns by the ratio of leverage. This can be very rewarding when the market moves in the anticipated direction. However, it can also be very costly when the market moves against the trader.
Advantages and Disadvantages of Leverage in Trading
| Advantages | Disadvantages |
|---|---|
| You can access markets that might be inaccessible without leverage | While it increases potential profits, it also increases potential losses |
| Increases the profits you can generate in the markets | Increases the risks involved |
| Allows you to operate in the market with amounts greater than your initial capital | Reduces the rate of return on your investment in case of loss |
| Improves the rate of return on your investment |
As you can see, leverage is a double-edged sword that must be handled with care.
It’s important to remember that using leverage is a risky process, and your deposit can be lost quickly when trading with high leverage.
Try to avoid very high leverage levels before you have enough experience.
Leverage in Forex – Conclusion
We hope this article has been helpful, and that you have now clearly understood what leverage is, how to calculate leverage in Forex, and the implications of leverage in your trading strategy.
Remember, trading with leverage is risky because it allows you to operate with higher volume, which can translate into greater profits, but also greater losses. Try to avoid highly leveraged trading before you have gained sufficient experience.
Therefore, leverage in Forex can be your best friend if used correctly and not overtrading, and your worst enemy if used excessively.
3 Tips for Using Leverage
- If you are a beginner trader, we advise using reduced leverage, as this will also reduce your potential losses.
- Practice first on a free demo account with virtual funds.
- Choose a regulated and reliable broker, where you can adjust your leverage.
Once you have acquired the necessary experience, put all you have learned into practice in a real trading account.