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Forex Leverage Explained
Leverage can be a controversial subject, as there are many different opinions on whether using leverage is good or bad.
Join me as I explain the basics, debunk the myths, define the challenges, and dispel the misconceptions of using leverage when trading Forex... Welcome to your ultimate guide to Forex leverage!
"Leverage enables traders and investors to make large returns with a small amount of capital. On the other hand, leverage also enables a trader to lose much 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"
Leverage for Beginners
When starting your Forex trading journey, there is so much 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. To add to this list, understanding leverage is another critical piece of knowledge you must gain to succeed in trading.
At the end of this guide, you should know what leverage is, why it is needed in your trading, the advantages of trading with leverage and the risks involved.
What is leverage in Forex trading?
Leverage is the term used to denote the borrowing of 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, it is possible to hold a 1,000 GBP position with just 500 GBP or much less.
Leverage enables a trader to open larger positions than the funds they have 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?
Leverage is offered by Forex brokers. 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 with your broker. Generally, the leverage amount is agreed on account opening.
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 required to be funded by the trader. 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.
Most respected and well-regulated brokers will offer 1:30 leverage as standard.
I have links for high-leverage Forex brokers and the best Forex brokers by country.
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 are trading with leverage, the broker potentially receives higher commissions as the position sizes are more significant.
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Competition. All Forex brokers offer leverage. To remain competitive with other brokers, a Forex broker must provide leverage.
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Extra charges. Most Forex brokers charge additional fees for holding leveraged positions, which means extra revenues for the broker.
Why use Leverage?
Using leverage enables traders to hold more prominent trading positions than they could do otherwise. 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 are looking to open your first trading account with just 100 GBP, EUR or USD, then you will not have enough capital to trade with unless you trade with 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 under 1% in value per day. This differs from stocks that can double or triple in a very short time.
Due to the incremental movements of the Forex market, leverage is needed to make the trade worthwhile.
Most professional stock traders do not use any leverage when trading, but most professional Forex traders use at least a 1:5 leverage ratio.
Without leverage, I would not be trading Forex, as the returns would not be worth it!
Leverage Advantage #3 - Bigger returns
As just mentioned, leverage enables more significant returns.
Catching a 2% currency move could mean a 2% gain on a non-leveraged account. The same move could mean a 60% return of a leverage account of 1:30!
Leverage Advantage #4 - Less funding required
There is a risk in holding funds with Forex brokers. 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. The rest of your funds can be kept in your bank account, which is less risky than with your broker.
"Leverage has some great advantages, but it can be a double-edged sword... The leverage that can be used to increase gains and protect capital can also be used to blow trading accounts and cause great trading challenges... You must understand leverage and use it to your advantage"
The Risks of using Leverage
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 significant hindrance and can be the reason why traders they fail.
If you know the risks of using leverage, you have a better chance of avoiding the pitfalls and dangers of using leverage.
The dangers of using leverage include:
Large losses
Using leverage can result in much bigger wins, as mentioned earlier on this page. Using leverage can also result in significant losses, however.
If it's possible to make a 2% currency move be a 60% gain using leverage, then the opposite is also true - a 2% move could be a 60% loss if price moves against your position.
Always using a stop-loss is one way to avoid this from happening. Because of leverage, stop-losses may have to be tighter or position sizes may have to be smaller to avoid having significant losses.
Losing more than you deposited
Do not hold high-leverage positions over the weekend or during significant 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 the above were to happen, with high-leverage positions, you could potentially lose all the funds in your trading account plus more, resulting in your trading account having a negative balance. Any negative balances are owed to the broker, and you must pay by law.
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 can result in higher chances of a margin call.
A margin call is when there is insufficient capital in your trading account to fund your open positions. When a margin call happens, your broker automatically closes positions until you have sufficient capital to meet margin requirements of any remaining open positions.
Always ensure you have sufficient capital and that you are not over-trading. Having too many positions open or letting losses run usually results in a margin call.
Increased trading emotions and psychological pressures
The greater the monetary swings in open positions, the greater the risk you take and the greater the emotional and psychological challenges you will have. High leverage and trading emotions are often linked.
Using an extreme example, a trade risking 50% of your account will gain much more emotional attachment than a trade risking 1% of your account.
Keep losses small, and always plan to risk a small percentage of your account. This is made much easier by using a stop-loss.
Read my Ultimate Guide to Trading Psychology to learn more about trading emotions.
Useful links:
Margin Calculator: myfxbook Forex Margin Calculator
High-leverage Forex Broker (1:500): IC Markets
Further Reading: Investopedia - Forex Leverage: A Double-Edged Sword