Leverage in Forex: a double-edged sword
One of the reasons for the popularity of Forex among traders in comparison with other financial instruments is the possibility of using a large leverage. Despite the ubiquitous use of the term “leverage”, few understand its true meaning and impact on trading.
What is Leverage?
Leverage allows traders to use borrowed funds to purchase an investment instrument. When trading on the Forex market, borrowed funds are provided by a broker. The availability of large leverage in Forex allows traders to manage significant amounts in the market with only a small amount of their own funds used to cover the margin requirements. To calculate the leverage, you must divide the total trade amount by the required margin amount.
|Total transaction amount|
|Required margin amount|
For example, if you need to deposit 1% of the total transaction amount, and you intend to operate with one standard lot USD / CHF equal to $ 100,000, the required margin (collateral) amount will be $ 1,000. In this case, the leverage is 1: 100. Likewise, if the margin requirement is 0.25%, the leverage will be 1: 400.
|Credit shoulder||Required sum margin (at percent)|
Trading on margin does not always carry additional risks. If a trader has sufficient funds of his own, the use of leverage will not necessarily affect his profit and loss. First of all, it is necessary to take into account not the size of the leverage offered by the broker, but the percentage of own funds used in trading, that is, the actual leverage.
To calculate the actual leverage, you need to calculate the ratio of the total amount of open transactions to the amount of equity.
|total amount open deals|
|Actual leverage =||
|Amount of equity trading capital|
For example, if your trading capital is $ 10,000 and you open positions for $ 100,000 (standard lot), the actual leverage will be 1:10. If, other things being equal, you are trading with two standard lots ($ 200,000), the actual leverage will be 1:20.
Most traders refrain from using all of their funds in trading, therefore the leverage provided by the broker is usually different from the actual leverage used by the trader.
Leverage in market trading Forex
When trading on the Forex market, traders track price movements in points, that is, in hundredths or ten-thousandths of the value of a currency pair (depending on the pair). However, price movements of a few pips are negligible in percentage terms. For example, if the GBP / USD pair rises by 100 pips from 1.9500 to 1.9600, in fact the rate changes by only 1 cent.
It is for this reason that it is necessary to use leverage to purchase large volumes of currency pairs and make any significant profit. If a trader is trading $ 100,000, a 100 pip move will bring him significant gains or losses. Forex trading allows the trader to use actual leverage that is appropriate for his trading style, nature and money management rules.
Excessive leverage risk
Using leverage proportionally increases not only potential profits, but also losses. The higher the percentage of equity capital a trader uses in trading, the higher the risk assumed. It should be noted that the actual leverage plays the leading role, not the leverage offered by the broker.
Let’s give an example. Trader A and Trader B each have $ 10,000 in their trading accounts with 1: 100 leverage. After analyzing, both traders conclude that USD / JPY is peaking and should fall in value, and are short at 120. Trader A uses an actual leverage of 1:50 and sells USD / JPY for $ 500,000.
Since the current rate is 120, a 1 pip move for a standard lot is approximately $ 8.30, so a 1 pip move for 5 lots is $ 41.50. If USD / JPY rises to 121, Trader A will lose 100 pips, or $ 4150, which is 41.5% of equity in one single trade.
Trader B is more careful and uses an actual leverage of 1: 5.
The amount of the trade to be opened in this case is equal to $ 50,000 or half of the standard lot. If USD / JPY rises to 121, Trader B’s loss is only $ 415, or 4.15% of total trading capital.
Below is a summary table for the above example.
|Trader A||Trader B|
|Trading capital||$ 10,000||$ 10,000|
|Actual leverage||1:50||1: 5|
|Total amount of the trade||$ 500,000||$ 50,000|
| Losses in case of movement against an open position
by 100 points
|4150 $||415 $|
|Loss of capital as a percentage||41.5%||4.15%|
|Remaining capital as a percentage||58.5%||95.8%|
Using the minimum actual leverage, the trader achieves comfortable trading conditions due to the possibility of setting more distant, but reasonable stops, allowing to reduce possible losses.
Using high leverage can wipe out a trader’s account balance in the event of an unfavorable market situation due to large percentage losses. It should be remembered that the trader himself chooses the leverage according to his needs.
The goals should be reasonable and you should not plan to make a million by the end of the month or year by using high leverage.