Leverage Explained - The Ultimate Guide to Leverage
Leverage can be a controversial subject... There are lot's of different opinions on whether using leverage when trading is a good or bad thing
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 The Ultimate Guide to Leverage!
"Leverage enables traders and investors to make large returns with a small amount of capital. On the flip side, leverage also enables a trader to lose a lot of capital, very quickly. The key is to understand leverage before you use it... This guide should 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, CFD's, and trading platforms are just some of the things you will encounter on your learning curve. To add to this list, understanding leverage is another key piece of knowledge you will need to gain, if you wish to succeed in trading.
At the end of this guide, you should know what leverage is, why it may be needed in your trading, the advantages of trading with leverage and the risks involved...
What is leverage?
Leverage is the term used to denote the borrowing of money in order to fund a trading position. Leverage is not like a credit card or loan though, it is very different.
A new trader may think that buying £1,000 of EURUSD would require a £1,000 investment. Without leverage, this thought process would be true. With leverage though, it is possible to a hold a £1,000 position with just £500 or less.
Who offers leverage?
Leverage is offered by Forex brokers. It is often optional.
When you open a trade, the amount required of you to fund a position/trade is determined by the amount of leverage you have agreed with your broker. Generally, the leverage amount is agreed on account opening.
Leverage is often displayed in ratios, rather than monetary amounts.
A leverage of 1:2 means that half a position will be funded by you, the other half will be funded by the broker through leverage - the 1 being your part, the 2 representing the full size of the position. This ratio could also be shown as a fraction of 1/2 - half of the trade is funded by you.
A leverage of 1:10 would mean that 1/10th of all trades will be funded by you, so a £1,000 position would only require £100 of capital.
What is trading on margin?
Margin and leverage go hand in hand. Margin is basically the percentage or monetary amount of a position funded by the trader.
For example, a trade that is taken with a leverage of 1:10 would require a margin of 10%... See below for more examples...
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
Margin percentage, 100%
Margin required £500
Example 2 - Leverage of 1:10
Position size, £2,000
Margin percentage, 10%
Margin required £200
Example 3 - Leverage of 1:500
Position size, £1,000
Margin percentage, 0.2%
Margin required £2
Forex brokers offer a variety of leverage amounts.
A well established and professional brokerage usually offers between 1:2 to 1:30 leverage ratios. Some financial regulators have banned Forex brokers from offering anything over a 1:30 leverage ratio. There are brokers available though that can offer as high as 1:1000 leverage!
Why do Forex brokers offer leverage?
Offering leverage to clients has many advantages for a broker. These include...
Enabling clients to trade. Some traders cannot trade unless they have leverage, as their actual account balance is too low to trade minimum position sizes
Increased commissions. Brokers charge commissions based on the overall position size i.e. After leverage. If clients are trading with leverage, this means potentially higher commissions for the broker.
Staying competitive. All Forex brokers offer leverage. To stay competitive with other brokers, it's vital that a Forex broker offers leverage.
Extra charges and fees. Most Forex brokers charge extra fees for holding positions on leverage. Meaning extra revenues for the broker.
Why use Leverage?
As mentioned already, using leverage enables traders to hold larger positions than they could do otherwise. This has some key advantages when it comes to trading...
Leverage Advantage #1 - It enables some traders to actually trade
New traders with small trading accounts may require leverage in order to actually trade. The smallest position sizes in the Forex market - without leverage - 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 are not going to have enough to actually trade with unless you trade with leverage.
Leverage Advantage #2 - Forex requires leverage
Though the Forex market may seem volatile at times, it really isn't. A 2-3% move on a currency pair is considered major move. Most often, Forex pairs move under 1% in value per day. This is nothing when compared to stocks that can double or triple in a very short space of time.
Due to the incremental movements of the Forex market, leverage is needed in order to make the trade worthwhile. To put this into context, 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 just not be worth it.
Leverage Advantage #3 - Bigger returns
As just mentioned, leverage enables bigger returns. Catching a 2% currency move could mean a 2% gain on a non-leveraged account. The same move could potentially mean a 60% return of a leverage account of 1:30!
Leverage Advantage #4 - Less funding required
There is 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 savings account, which is probably a lot 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 need to understand leverage and use it to your advantage, not your disadvantage"
The Risks of using Leverage
So far, I have explained most of the positive aspects of trading with leverage, including the what, why, and how of leverage. Unfortunately for some traders, leverage can actually be a major hindrance and can be the reason why traders lose too much, become too emotional and even blow trading accounts.
If you know what the risks of using leverage are, then you have a better chance of avoiding the pitfalls and dangers of using leverage.
The dangers of using leverage include...
Using leverage can result in having much bigger wins, as alluded to earlier in this post. Using leverage can also result in large losses though.
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!
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 large losses.
Losing more than you deposited
Do not 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 is able to close your position - both scenarios resulting in stop-losses not being honoured (triggered) at your desired price.
If the above was 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 will have to pay by law.
To avoid this, use a broker that offers negative balance protection. Also never hold highly leverage positions over the weekend or during major economic news events.
Having highly leveraged positions can result in higher chances of having a margin call.
A margin call is when there is insufficient capital in your trading account to fund the positions you have open. When a margin call happens, your broker will automatically close positions down until you have sufficient capital to meet margin requirements.
Always ensure you have sufficient capital and that you are not over-trading. Having too many positions open or letting losses run is what usually results in having a margin call.
Increased trading emotions and psychological pressures
The greater the monetary swings in open positions and the greater amount of risk you are taking 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 that is worth 50% of your account is going to gain much more emotional attachment than a trade that is worth 1% of your account.
Keep losses small and always plan of risking a small percentage of your account. This is made much easier by using a stop-loss.
To learn more about trading emotions, read my Ultimate Guide to Trading Psychology.
With leverage in mind, which Forex Broker should I use?
Placing emphasis on leverage and reducing risk caused by leverage, the best brokers are those that are well regulated.
For example, FCA regulated brokers have two main leverage advantages...
1. Leverage is capped at 1:30 for new traders. Making it harder to become over-leveraged and taking large losses.
2. All FCA brokers offer negative balance protection.
List of FCA regulated brokers
If you want to explore other FCA regulated brokers, then try IG, eToro, Oanda and Pepperstone.
If you need assistance calculating required margin for a position, then I suggest using a margin calculator.
You can use this one for free.