Leverage is a complicated name for a straightforward concept: Leverage is borrowing money when trading on the Forex market or in other financial instruments. Leverage allows forex traders to magnify the power of their initial capital. With leverage, a trader with limited funds can still open and control large trading positions. Leverage boosts a trader’s potential profits (as well as their potential losses), which are still based on the full value of the position.
Leverage brings great benefits to traders, but it also carries huge risks, so it is vital you thoroughly understand the concept before you use it.
How does Leverage work in Forex Trading?
Most brokers offer leverage to their clients, so as a trader you are effectively borrowing money from your broker. The amount of capital you open a trade with is known as the margin. With leverage, you can borrow up to 30 (100/200/500/1000 depending on CFD provider and financial regulation) times that amount. So, for example, although you may have only US$500 to trade with, you can control a trade worth US$15,000 (50,000/100,000/250,000/500,000) through leverage.
One of the key advantages of trading Forex as opposed to, say, stocks are that you get much higher levels of leverage. While the leverage ratio may be as high as 500:1 in Forex, you can probably only find leverage of 5:1 in the stock market.
Another way of looking at leverage is by the amount of margin you need to open a trading position. So, if a broker allows you leverage of 30:1, you will be required to put up a margin, or deposit, of just 3.3% (or US$3300 to open a trade of US$100,000). A Forex margin of 10% equates to a leverage of 10:1, while a margin of 3.3% equates to 30:1 and so on.
Figure 1: How leverage allows you to turn capital of US$3300 into a trade worth US$100,000
Source: CMC Markets
You may have heard the phrase “margin call”. This occurs when the equity in your account – the total capital you have deposited, plus or minus any profits or losses – drops below your margin requirement. Should that occur, there is a risk that your positions will be automatically closed by your broker, locking in any losses, so margin calls should be avoided. That can be done by adding funds to your account or closing the trade sooner.
The margin level needs to be continuously monitored to avoid a margin call. Traders can also reduce the chance of margin calls by implementing risk-management techniques.
What is the Best Level of Leverage in Forex for Beginners?
The amount of leverage you can apply to trades depends on the broker. Most brokers in well-regulated markets limit leverage to 30:1. However, just because that is the maximum you are allowed does not mean you have to trade every position with 30:1 leverage. Indeed, professional traders tend to trade with modest amounts of leverage to protect their capital. As a beginner, you should start with very low levels of leverage – and only after you have practised using leverage on a demo account until you are completely comfortable with the concept.
Remember, too, that even if you are an experienced trader, keeping your leverage low protects your capital when you make trading mistakes and keeps your returns consistent. It takes considerable experience to really know when to apply leverage and when not to.
How does Leverage Effect Profit in Forex Trading?
The best way to understand exactly how leverage maximises profits is by using an example. So, imagine you want to trade the USD/USD currency pair. A standard lot consists of US$100,000. If you had US$100,000 and bought a position at 0.86 and closed the position at 0.87, the price difference would amount to 0.0100 (100 pips). You would therefore make a profit of US$0.01 times 100,000, i.e. US$1000 or only 1% of your total capital of US$100,000.
However, if you used 100:1 leverage, you would only need capital of US$1000 to be able to control a trading lot of US$100,000. Now imagine you conduct that previous trade using 100:1 leverage. This time, your initial outlay is just US$1000 and you still make the US$1000 profit, so the return on your investment is 100%.
Moreover, your US$100,000 of capital would allow you to buy up to 100 lots. In other words, you could make a profit of US$100,000 using leverage, compared with just US$1000 without using leverage, while staking the same amount of capital. That is how leverage magnifies profits.
Remember, though, this is simply an example to show you how leverage works. We are not suggesting you should carry out a trade like this using extreme levels of leverage!
What is Free Margin?
Forex free margin is the amount of money in a trading account that is available to open new positions. It can be calculated by subtracting the used margin from the total amount deposited in an account (the account equity) and adding or subtracting the unrealised profit or loss from any open positions. If you have an open position that is currently in profit, you can use this profit as additional margin to open new positions on your trading account. If, for example, you have US$5000 in your account and are in profit by a further US$5000 in open trading positions, your free margin amounts to US$10,000.
How to use Leverage in Forex trading
While leverage can increase your potential profits, it can also increase your potential losses. You can avoid the potentially negative impact of leverage by using risk-management tools provided by brokers.
These tools include stop-loss orders. You can set these orders automatically with your broker so that if a trade moves in the opposite direction to the one you expected, the trade is closed when it passes below a certain level. That limits your losses, effectively providing insurance against how much you can lose. While no trader sets out to lose money, it is best to have a means of keeping the losses small.
For more on this risk management tool and why it is essential for all Forex traders read our article on stop-loss orders.
Other ways to manage risk when using leverage are to keep positions small and to limit the amount of capital for each position.
How to Calculate Leverage in Forex
Calculating leverage is very straightforward. You just need to use the formula below.
Leverage = 1/Margin = 100/Margin Percentage
Imagine, for example, you have U$10,000 in your trading account. With a margin of 1%, you are able to open positions to a total value of US$1,000,000 (US$10,000 ÷ 0.01 = US$1,000,000).
Many brokers also provide margin calculators.
Margin Calls and Liquidation
If the losses on an open trade reach a certain level, the broker may close the position to prevent more significant losses. The liquidation level is set where the margin ratio falls below a certain point (usually 20%, but this can vary).
Imagine you have an account balance of US$10,000 and open a position that requires a Forex margin of US$1,000.
The market moves against you leading to an unrealised loss of $9,000, reducing your equity to US$1,000 (i.e. US$10,000 – US$9,000). Your equity is equal to your margin, meaning your Forex margin level is 100%. Consequently, you won´t be able to open any new positions on your account, unless the market turns around and your equity increases again or you deposit more cash into your account.
Now suppose the market keeps moving against you. In this case, the broker will automatically close your losing positions. The limit at which the broker closes your positions is based on the margin level and is known as the stop out level, which varies from broker to broker.
When the stop out level is breached, the broker will close your positions in descending order, starting with the largest position first. Closing a position will release the used margin, which in turn will increase the Forex margin level, which may bring it back above the stop out level. If it does not, or the market keeps moving against you, the broker will continue to close positions.
Leverage increases both profit potential and risk considerably. To learn more about leverage and how a margin forex trading account works, please read ‘What is Equity and Margin?’
