Forex trading has become very popular as it offers the usage of leverage. This means that we can borrow money to trade larger positions in currency, so we are only required to put up a small amount of money (known as margin) to control a much larger amount of money for trade. This allows traders to open short-term forex positions without investing thousands of US dollars worth of their capital. But the leverage is a double-edged sword, meaning it can increase our profits but also magnify our losses.
It is important that forex traders gain knowledge about how to manage leverage and develop their risk management strategies to mitigate significant losses of money.
LEVERAGE IN THE FOREX MARKET
The forex market is the largest of the trading markets in the world, having around $6 trillion worth of currency exchanges every day. This involves buying and selling the exchange rates of currencies. The main goal is that the rates will move in our favor, so we could gain profits.
To enhance profits, investors and traders use leverage in trading. For this reason, the forex market offers one of the highest amounts of leverage available among all the available markets. The meaning of leverage is actually a loan that a broker gives to a trader, so our account is established to allow trading on margin or borrowed funds.
So the more leveraged we are, the higher risk we are facing. But on the flip side, it also gives us a greater opportunity to profit.
Some of the global forex brokers have limitations in the amount of leverage, this especially is in use with the new traders which are usually less experienced in the market. Traders can then tailor the amount or size of their trades, based on the leverage they have. The broker will, however, always require a certain percentage of the trade’s notional amount to be held in the account as cash. This is called the initial margin.
LEVERAGE RATIO TYPES
The forex brokers have to manage their risk and in doing so, they will increase a trader’s margin requirement or reduce the leverage ratio. Or it other words, our trading position size. While we are used to seeing the equities leverage from 1:1 to 1:5, the futures market allows up to 1:15 leverage. As the currency prices usually change by less than 1% during normal intraday trading, brokers allow leverages higher than 30:1, 100:1, etc. in forex market.
The initial margin is required by each broker and can vary, depending on the size of our trade. If we buy $100,000 worth of EUR/USD currency pair, brokers could require us to hold $1,000 in the account as margin. In other words, this means the margin requirement would be 1% of the trade size, in our case: $1,000 divided by $100,000.
The leverage ratio tells us how much the trade size is magnified as a result of the margin held by the broker. If we, for example, use the initial margin mentioned above, the leverage ratio for out trade would equal 100:1 ($100,000 / $1,000). In other words, this means that for a $1,000 deposit, we can trade $100,000 in a particular currency pair.
Let us now see some examples of margin requirements and the corresponding leverage ratios.
As we can quickly notice from the table above, the lower the margin requirement is the greater amount of leverage that can be used on each trade. Some brokers may also require higher margin requirements, depending on the particular currency being traded. This is usually happening when we trade the British pound versus the Japanese yen (GBP/JPY), as the exchange rate can be quite volatile with this currency pair.
So a broker could require more money to be held at the account as collateral (even up to 5 percent) for more volatile currencies and during those extreme price movement periods. When only a low amount of leverage, e.g. 20:1 or 30:1 is allowed, brokers will usually have a 10-15% margin requirement for emerging markets like exotic currencies (for example Mexican Peso, South Africa Rand, etc.).
TYPICAL LEVERAGE AMOUNTS
The majority of the brokers set the leverage in a fixed amount and each broker gives out the leverage amount based on their own rules and regulations. These are the typical amounts:
- 50:1
- 100:1
- 200:1
- 400:1
- 500:1
Let’s see what exactly this means.
For example, the leverage amount of 50:1 means that for every $1 we have in our account, we can place a trade worth of $50. So if we deposited $1000, we would be able to trade amounts up to $50,000 on the market. The most typical amount of leverage is 100:1, this means that we can trade 100 times more than our deposited amount (we deposited $1000, so we can trade with up to $100.000).
Above: The required margin for $100k traded amount based on leverage ratio
Some global brokers do provide also larger amounts of leverage, for example, 400:1 or even 500:1. So, the 500:1 leverage means that for every $1 we have in our account, we can place a trade worth of $500. But trading with such extreme leverage amounts is also very tricky.
Imagine that you deposited $400$ into your forex account and use the leverage of 500:1. With just a very small movement of the market in the opposite direction you opened your position, it could wipe out your whole account in a matter of minutes. Even just in a few seconds when the market is very volatile.
FOREX LEVERAGE CALCULATOR
So how do we calculate the forex leverage?
A forex leverage calculator can help traders to determine how much capital we need that we can open a new trading position, as well as manage our trades. This calculator also helps us to avoid margin calls as we can determine optimal position size.
The formula for forex leverage is the following:
We can also start with the margin amount and apply the leverage ratio to determine the position size. In this case, the formula would be A = E x L, as we are multiplying the margin amount by the leverage ratio to get the asset size of our trading position.
BENEFITS OF USING LEVERAGE
As we learned how leveraged trading works and how it magnifies risk, it can also be an extremely powerful thing. Below are a couple of the main benefits:
- Magnified profits – We only have to put down a small fraction of the value in our trade to receive the same profit as we would in conventional trade. This is because profits are calculated using the full value of your position, so margins can multiply your returns on successful trades. But it works the other way too, it will also multiply your losses if the price goes against your favor.
- Gearing opportunities – When we use leverage, this can also free up capital that can then be used in other investments. This ability to increase the amount available for investment and trading is known as gearing.
- Shorting the market – Using leveraged products to speculate the market movements also brings us to the benefit from markets that are falling, and indeed those that are rising. This is known as going into a short trade.
- 24-hour trading – Forex markets are available to trade around the clock, 5 days a week.
DISADVANTAGE OF USING LEVERAGE
We indeed are happy being able of using leverage, giving us the ability to earn significant profits. But this medal has two sides, as the leverage can also work against traders. For example, if the currency underlying one of our trade moves in the opposite direction of what we speculate would happen, the leverage will significantly amplify your potential losses as well.
To avoid damaging our trading account, we have to implement a strict trading style. This means that we are required to use Stop-Loss (SL) orders to control potential losses. A stop-loss is a trade order with your broker which will close/exit your position if the price reaches a certain level. With us setting a stop-loss, we will easily save ourselves from the huge losses a wrong trade could bring.
Below are some additional disadvantages of using leverage:
- Magnified losses – Using margins magnify losses as well as profits, so our initial balance is comparatively smaller than conventional trades with 1:1 to 5:1 leverage. So it could be quite easy to forget the amount of capital we are actually putting at risk. Always consider your trade in terms of its full value and the potential downside too, and take steps to include risk management with stop-loss.
- Margin call – If our position moves against us, the broker may ask you to put up additional funds to your account in order to keep your trade open. This is known as the margin call. If this happens, we are required to either add more capital to increase our account balance or exit open positions to reduce our total exposure.
- Funding charges – When we are using leverage, we are actually effectively being lent the money to open the full position at the cost of your deposit. This is indeed not given for free by your broker. So if we want to keep our position open overnight or for a few days, the broker will charge us a small fee to cover the costs of doing so. This is known as the overnight fee.
HOW LEVERAGE AFFECTS THE PIP VALUE?
In forex, different accounts have specific lots and pip units. While a lot is the minimum quantity of a security that can be traded, the pip is the smallest amount by which a currency quote can change. A standard account has 1 lot worth $100,000, while the pip unit is stated in the amount of $0.0001 for U.S.-dollar-related currency pairs. This is actually the most common pip unit, used for almost all currency pairs.
So a pip value tells us the effect that a 1 pip change has on a dollar amount. And the pip value doesn’t vary based on the amount of leverage we use. It is rather the opposite, the amount of leverage we have on our account affects the pip value. If our broker allows us a 100:1 leverage, this means that for every $100,000 transaction, the broker will require you to have $1,000 in your account (100:1 = $100.000 / $1.000).
Calculating Pips and Leverage
As we learned, a standard lot has the size of $100,000, and the value of one pip is $10 (calculated as $100,000 x 0.0001). If our account contains $10,000 and we have a leverage of 100:1, then we will have $1.0 million ($10,000 x 100) or 10 lots ($1,000,000/$100,000) that we can use for trading.
So, leverage is basically the amount of money we can spend as a result of borrowing investment capital from the broker. As the higher leverage also means that our position is riskier, a decrease of only a few pips could mean we will be losing a lot of money.
For example, without having proper risk management and a stop-loss, it would be extremely risky to use the entire $1.5 million that you have available as each 1 pip is worth $150. A quick calculation tells us that we would clean out our account just by losing 67 pips ($10,000/150).
Most forex calculations are displayed in pips. So, to determine our gains or losses, we have to convert our pips to our currency. If we trade the USD for example and the trade closes, multiplying the pip difference by the number of traded units will give us the total pip difference between the opening and close of the trade. If the quoted price is USD, the pips are expressed in USD. If the U.S. Dollar is the base currency, convert the pip value to USD.
Above: Calculating profits and losses depending on leverage and pip change
The bottom line is never over-risk your trade.
When we are trading a currency against another, the value of one pip is the quoted price, not the base price. For example in a EUR/USD position, the pip value is in USD (0.0001 USD). However, the opposite of these pairs, USD/EUR, the pip value would be 0.0001 EUR. Let’s say that the conversion rate from Euros to Dollars is 1.25, then one Euro pip equals 0.000125 Dollars.
THE CONCLUSION
When we use leverage in forex, we are borrowing the money from a broker, so we are able to open larger positions in a currency. The leverage magnifies the returns (profits) from the movements of currency pairs in our direction. But it can also go in the opposite direction, meaning usage of large leverage can also magnify losses very quickly.
Increasing the leverage also increases the volatility of our position because even small changes in pip value will result in larger fluctuations in the account value (profit or loss). Although we have to be aware there is a large downside risk using high leverage, there is also a bright side of it, a potentially large upside gain.
This is why using leverage in finance is so attractive, but it certainly requires a high level of knowledge to achieve proper risk management with your account.