ACTUAL FOREX TRADING
Forex Leverage: Explained
Leverage can be controversial, with many opinions on whether it's good or bad.
Join me as I explain the basics, debunk the myths, define the challenges, and dispel the misconceptions about using leverage when trading Forex. Welcome to your Ultimate Guide to Forex Leverage!
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"Leverage enables traders and investors to make large returns with a small amount of capital. On the other hand, leverage can also cause a trader to lose capital very quickly. The key is to understand leverage before you use it... This guide will provide you with a clear understanding of leverage and help you make better leverage choices"
Forex Leverage: The Basics
When you start your Forex trading journey, there is a lot to learn. Technical indicators, fundamental analysis, Japanese Candlesticks, price patterns, spreads, brokers, CFDs, and trading platforms are some things you will encounter on your learning curve. Add to this list an understanding of leverage; it is another critical piece of knowledge you must gain to succeed in trading.
By the end of this guide, you should know what leverage is, why you need it in trading, the advantages of trading with leverage, and the risks involved.
What is leverage in Forex trading?
Leverage refers to borrowing money to fund a trading position. However, leverage is not like a credit card or loan; it is very different.
A new trader may think buying 1,000 GBP of EURUSD would require a 1,000 GBP investment or down payment. Without leverage, this thought process would be valid. With leverage, though, you can hold a 1,000 GBP position with just 500 GBP or less.
Leverage lets a trader open larger positions than the funds in their brokerage account. With leverage, a trader can open a trade worth 10,000 USD with as little as 200 USD!
How to get leverage?
Forex brokers offer leverage. It is often optional.
When you open a trade, the amount required of you to fund the trade (position) is determined by the amount of leverage you have agreed to with your broker. Generally, you agree on the leverage amount when you open an account.
What are leverage ratios?
Leverage is often displayed in ratios rather than monetary amounts.
A leverage of 1:2 means that you will fund half a position, and the broker will fund the other half through leverage - the 1 being your part, the 2 representing the total size of the position. This ratio could also be shown as a fraction of 1/2 - you fund half of the trade.
Leverage of 1:10 means you fund 1/10th of all trades, so a 1,000 EUR position would only require 100 EUR of capital.
What is trading on margin?
Margin and leverage go hand in hand. Margin is the percentage of a position the trader must fund. The broker will fund the remaining position.
The leverage and margin graphic above will help you better understand margin and how it is calculated.
Leverage and Margin Examples
So, let's look at some examples of leverage and margin requirements when trading Forex:
Example 1
Leverage of 1:1 (no leverage)
Position size = 500 USD
Margin percentage = 100%
Margin required = 500 USD
Example 2
Leverage of 1:10
Position size = 200 GBP
Margin percentage = 10%
Margin required = 20 GBP
Example 3
Leverage of 1:500
Position size = 500 EUR
Margin percentage = 0.2%
Margin required = 1 EUR
How much leverage should you use?
Leverage of 1:30 to 1:100 is acceptable. You shouldn't need more than 1:100.
The most respected, well-regulated brokers offer 1:30 leverage as standard.
If you want a broker which offers high leverage, I recommend IC Markets.
Why do Forex brokers offer leverage?
Offering leverage to clients has many advantages. These include:
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Enabling clients to trade. Some traders can only trade with leverage, as their account balance is too low to open full position sizes. Leverage creates opportunities for more traders to participate in the market.
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Increased commissions. Brokers charge commissions based on the overall position size, i.e. the whole position, including the leveraged amount. If clients trade with leverage, the broker may receive higher commissions because position sizes are larger.
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Competition. All Forex brokers offer leverage. To stay competitive, a Forex broker must offer leverage.
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Extra charges. Most Forex brokers charge additional fees for holding leveraged positions, which means extra revenue for the broker.
Forex Leverage: Why use Leverage?
Leverage lets traders hold larger positions than they otherwise could. This has some key advantages when it comes to trading, such as:
Leverage Advantage #1 - It enables some traders to actually trade
New traders with small trading accounts may require leverage to trade. Without leverage, the smallest position sizes in the Forex market often require at least 1,000 GBP / 1,400 USD in funding. If you want to open your first trading account with just 100 GBP, EUR, or USD, you will not have enough capital to open positions unless you use leverage.
Leverage Advantage #2 - Forex requires leverage
Though the Forex market may sometimes seem volatile, it isn't. A 2-3% move on a currency pair is significant. Most often, Forex pairs move less than 1% per day. This differs from stocks that can double or triple in a very short time.
Because Forex moves in small increments, leverage is needed to make the trade worthwhile.
Most professional stock traders don't use leverage when trading, but most professional Forex traders use at least a 1:5 leverage ratio.
Without leverage, I wouldn't trade Forex, as the returns wouldn't be worth it!
Leverage Advantage #3 - Bigger returns
As mentioned, leverage enables bigger returns.
Catching a 2% currency move could mean a 2% gain on a non-leveraged account. The same move could mean a 60% return on a leveraged account with 1:30 leverage!
Leverage Advantage #4 - Less funding required
Holding funds with Forex brokers carries risk. If a broker goes bust, your funds could be in danger of never being returned.
With leverage, you can fund your trading account with only what is needed to fund your open positions, plus a small buffer. You can keep the rest of your funds in your bank account, which is less risky than keeping them with your broker.
"Leverage has some great advantages, but it can be a double-edged sword... The leverage that can increase gains and protect capital can also blow trading accounts and create major trading challenges... You must understand leverage and use it to your advantage"
Forex Leverage: The Risks
So far, I have explained the positive aspects of trading with leverage, including the what, why, and how of leverage. Unfortunately for some traders, leverage can be a major hindrance and may be why they fail.
If you understand the risks of using leverage, you have a better chance of avoiding its pitfalls.
The dangers of using leverage include:
Large losses
As mentioned earlier on this page, leverage can lead to much bigger wins. However, it can also result in significant losses.
If a 2% currency move can become a 60% gain with leverage, then the opposite is also true: a 2% move can become a 60% loss if price moves against your position.
Always using a stop-loss is one way to avoid this. Because of leverage, stop-losses may need to be tighter, or position sizes smaller, to avoid significant losses.
Losing more than you deposited
Don't hold high-leverage positions over the weekend or during major news events. A market can gap over the weekend, and markets can move faster than your broker can close your position at your stop-loss - both scenarios resulting in stop-losses not being honoured (triggered) at your desired price.
If this happens with high-leverage positions, you could potentially lose all the funds in your trading account, plus more, resulting in a negative balance. You must pay any negative balance owed to the broker.
To avoid this, use a broker that offers negative balance protection. All UK-regulated brokers offer negative balance protection. Also, never hold highly leveraged positions over the weekend or during major economic news events.
Margin calls
Highly leveraged positions increase the risk of a margin call.
A margin call occurs when your trading account has insufficient capital to fund open positions. When a margin call happens, your broker automatically closes positions until you have sufficient capital to meet the margin requirements of any remaining open positions.
Always ensure you have sufficient capital and that you are not over-trading. Too many open positions or letting losses run usually results in a margin call.
Increased trading emotions and psychological pressures
The bigger the monetary swings in open positions, the greater the risk you take and the greater the emotional and psychological challenges you face. High leverage and trading emotions are often linked.
For example, a trade risking 50% of your account will create much more emotional attachment than a trade risking 1%.
Keep losses small, and always plan to risk a small percentage of your account. A stop-loss makes this much easier.
Read my Ultimate Guide to Trading Psychology to learn more about trading emotions.
Useful links:
Margin Calculator: myfxbook Forex Margin Calculator
Recommended broker with leverage options from 1:1 to 1:500: IC Markets
Further Reading: Investopedia - Forex Leverage: A Double-Edged Sword