What Is Leverage in Forex Trading?
The use of leverage in forex trading is the process of using borrowed funds to increase your trading position.
Leverage is offered by brokers and allows traders to hold positions beyond the limitations of their cash balance, which can significantly increase their return on investment. It does, however, also increase risk and can amplify losses.
Leverage should be carefully considered and used sensibly. It is important to always employ a solid risk management strategy. Consistent returns should be prioritised over risky trades that have the potential to do financial damage if the market was to move in an unexpected direction.
This article will explore the use of leverage for forex trading in greater detail, particularly regarding the risks involved and how these can be partially mitigated.
Why Is Leverage Used in Forex Trading?
In forex trading, investors use leverage to maximise the profits they can make from currency fluctuations.
In the forex market, currency fluctuations are very small pip movements. This means that the profit made on each trade tends to be small, hence the pace of forex trading and the large number of trades required to make a substantial profit.
Note: A pip is the smallest exchange price movement that can occur between a currency pair and stands for ‘percentage in point’.
With the use of leverage, traders can carry out larger currency transactions – opening orders much greater than their capital allows – which can translate price movements into more sizable profits.
Leverage allows forex traders to see increased movements in their accounts as without leverage, movements would be small and dependent upon the capital the trader tangibly has. With leverage, traders could easily see a 10% movement in a day, meaning vastly increased profits.
How Does Leverage Work in the Forex Markets?
When trading in the forex market, traders tend to be able to secure much higher leverage than they would in other markets – the stock market, for example.
To put the high leverage amounts available in the forex market into perspective, a leverage ratio of 2:1 is usually provided in the equities market and 15:1 leverage ratio in the futures market. Leverage in forex tends to be offered at a ratio of 50:1 and above.
Note: 'Equity market' is another term for the stock market. Futures are financial contracts which obligate the buyer/seller to deliver a specified amount of a certain commodity on a certain date. The futures market is an exchange to buy and sell these futures contracts.
The leverage offered in forex is higher because currency prices usually fluctuate less than 1% in an intraday period, meaning that the risk to the lender is less.
While leverage is often defined by traders as a line of credit provided by a broker to their client, leverage does not have the features that come with credit. There is no deadline for settling the leverage provided by the broker and no interest.
A high leverage offer in forex trading means that a trader can control a large amount of money for a comparatively small initial margin requirement.
Note: An initial margin is the percentage of the purchase price of a security that needs to be covered by either cash or collateral when using a margin account.
Unpacking Leverage Ratios
In forex trading, the leverage offered will depend on the broker, the size of the account and the size of the position the trader intends to make.
The leverage will have a minimum deposit in place for use. The leverage provided is usually 50:1, 100:1 or 200:1.
- 50:1 – This leverage ratio means that for every £1 you have, a trade of up to £50 can be placed. This means that for a deposit of £500, you would be able to trade up to £25,000 on the FX market.
- 100:1 – This leverage ratio means that for every £1 in your account, you can place a trade of up to £100. On a standard lot account, this is the typical amount of leverage offered. The minimum deposit tends to be £2,000.
- 200:1 – A leverage ratio of 200:1 means that you can place a trade of up to £200 for every £1 in your trading account. This is the leverage ratio that tends to be offered on a mini lot account. The minimum deposit required is logically lower than that on a standard lot account, with an amount of £300 usually requested.
- 400:1 – A ratio of 400:1 means that for every £1, a trade of up to £400 can be placed. Whilst a ratio of 400:1 is offered by some brokers for mini lot accounts, it should not be offered on small accounts. Trading with a small deposit on a 400:1 ratio could finish your foray into trading in less than five minutes.
It is important to be sensible with the ratios you choose to trade with. You do not need to trade on the highest ratios that brokers offer; you can trade on a more conservative leverage amount by depositing more money and making fewer trades.
Just because the leverage is available, does not mean that you need to or should use it.
Leverage amounts such as 10:1 and 20:1 are most commonly used by professional traders. Experience will teach you when to use leverage and when it is best to avoid it but, as a rule of thumb, the less leverage used the better.
It is better to be cautious and have the capital to trade for longer, rather than wiping out all of your capital resources early on.
An Example of Leverage in Action
When using leverage, a loss can build up rapidly. The example below displays just how easily this can happen:
Trader A and Trader B both have capital of £10,000. Their broker requires a 1% margin deposit.
Scalping analysis indicates that taking a position on GBP/JPY should be profitable, so they short the GBP/JPY at 120 as they believe it is about to fall.
Trader A uses a leverage ratio of 50:1 taking a position sized at £500,000 (50 x £10,000 trading capital).
Trader B is more cautious and applies five times leverage and takes a position of £50,000 (5 x £10,000 initial trading capital).
The short was made at 120.
One pip for one standard lot = approx. £8.30, so one pip movement for the five standard lots = approx. £41.50.
The pip movement goes against these traders and rises to 121
Trader A has lost 100 pips, equivalent to £4,150. This is 41.5% of their total trading capital of £10,000.
Trader B has also lost 100 pips, but due to the lower leverage used this is equivalent to £415 and a loss of only 4.15% of total capital.
If the trade had gone the way the traders had hoped and expected, Trader A would have made substantially more profit than Trader B. Unfortunately, the high leverage used by Trader A made them extremely vulnerable if the trade did not evolve as predicted.
Trader A only has 58.5% of their trading capital remaining, whereas Trader B still has 95.8% of their capital intact. As a consequence, Trader B is in a much stronger position to make a profit going forwards.
What Are the Risks Involved With Leverage?
Leverage provides traders with the opportunity to increase their positions and make significant profits through the ability to fully exploit currency fluctuations. When using leverage, however, traders should be aware that while leverage can amplify gains in forex trading, it also amplifies any losses.
Leverage should be used wisely, alongside a realistic risk management strategy. Much of the risk in trading comes from the amount of leverage on the trade, not the movement of the asset itself.
When making a currency trade with values in excess of £100,000, even small fluctuations can result in huge losses or profits.
Forex traders should be sensible – they should not use all of their available margin, and only employ the use of leverage when the advantage is distinctly on their side.
Professional traders usually trade with very low leverage. Low leverage protects you from the financial impacts of trading mistakes and keeps your gains consistent.
There are certain situations when leverage should not be used; for example, in automated trading. This is the case because less discretion can be used.
Financial agencies and brokerages that offer leverage provide leverage warnings reminding traders about the high risk to their capital.
It is, however, important to remember that, when used correctly, leverage can be an efficient use of capital and its employment greatly widens the scope of the trading an individual can partake in.
How to Reduce the Risks Associated With Leverage
Using leverage to increase your trading position makes you more vulnerable. To reduce risk and control losses, forex traders tend to implement strict controls when trading using leverage by imposing stop-loss orders.
Stop-loss orders protect trades from unexpected market shifts. A stop-loss order is an instruction given to the broker that the trade must be exited when it reaches a certain price. When entering a trade, it is good practice to carefully consider the point at which you will exit and set up a stop-loss order indicating this figure.
Even if traders follow market trends closely, the volatility of the forex market means the protection from a stop-loss order is invaluable in protecting against the accumulation of small losses.
When you use a stop-loss market order to set your stop-loss price, as soon as the price nears your limit, a market order is automatically sent by the broker to close your position at the current price.
It is worth noting that stop-loss market orders differ from a conventional market order. With a market order, a trader outlines that they wish to trade a certain number of shares of a stock at the current market-clearing price. Basic market orders do not allow traders to set an exit price.
Using a stop-loss market order instead allows the investor to specify their limit price.
Depending on the conditions of the market, however, the trade may not be exited at exactly the stop-loss price. This difference is referred to as slippage.
A type of combined order referred to as a stop-loss limit order helps to eradicate losses from slippage. When the specified price is reached, a limit order is sent and the trade is made only at that price or better.
Using leverage has the potential to magnify the profits a forex trader can make from small market movements. With a low margin requirement, traders can leverage large amounts and make sizable trades that would not have otherwise have been possible.
To be successful and make a profit from forex trading, however, it is vital to use leverage responsibly. Traders must not max out the leverage that they have been offered by their broker.
As it has been stressed, trading with leverage can boost profits but also magnify losses. Due to the high volatility of the forex market, setting a stop loss when trading is highly recommended.
Used sensibly, leverage can be a useful tool to enable efficient use of capital and make enlarged profits. Always remember though, traders should only ever speculate with money that they can afford to lose.
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