Leverage in forex trading
Leverage allows you to enhance your profits
Leverage is essentially the borrowing of capital to increase your returns on investment. In the forex industry, a forex broker can “lend” capital to a trader, allowing the trader to open a much larger position, just as if they had a much larger trading account than they actually do. This means, however, that a trader can also lose just as much as if they had a much larger trading account.
Brokers can afford to make this arrangement because the losses are limited to the trader’s account balance only. Once the loss exceeds the the amount of money the trade has to start with, the broker will close all the trades that are currently open. This avoids the scenario where the trader has borrowed more than they have in their account and owes the broker money.
How forex leverage works
When a position is opened in the forex market, the market moves either in the direction of the trader’s position or against it. For each pip that the market moves, there is a fixed amount of capital added or taken away from the trader’s account. If the move is in line with the trader’s position, they make money; if not, they lose money.
Currency trading is completed in “contracts” for a standard amount of units called lots. Each lot is worth 100,000 units of a currency. Using the US dollar for denomination, if a trader opens a position with one standard lot, then he is buying or selling 100,000 units of that currency.
As the currency moves in pips – which are increments of 0.0001, each pip – when a standard lot is traded, it is worth $10 (0.0001 x 100,000 = $10). If the trade moves ten pips in favour, then the trader gains $100. If the trade moves ten pips against the position, then he is down by $100.
Not everybody has an account big enough to buy or sell $100,000 worth of a currency and so you can use leverage, i.e. borrow from the broker in order to trade $100,000 when you do not have $100,000 in your trading account.
When using leverage, the capital is lent to you when you open the trade, but you do not actually see this money go into your trading account. You do, however, see the effects when your trade is open, because each pip movement has a greater value, allowing for greater potential profit or loss.
Leverage requires a minimum amount in your trading account
Usually, in order for a trader to borrow capital to enhance their position size, they must put up a certain amount of capital themselves as a security – this is referred to as margin. In other words, in order to use leverage with a forex broker, you will have to have a minimum amount in your account to start with. This minimum amount will differ between brokers.
Different brokers lend different amounts
Different brokers also offer different amounts of leverage and these are expressed as ratios, such as 1:100, meaning that the amount lent to the trader is 100 times the amount they have in their trading account.
For example, if a broker offers a leverage of 100:1, then a trader can purchase a standard lot, which is $100,000 of currency, with just $1,000 – the $1,000 is the margin.
This means that a trader can trade with each pip being worth $10 and still gain $100 with just ten pips, but with only having $1,000 in their account instead of $100,000.
Maximum leverage is the maximum amount of leverage available to use at a particular time. This cap is set by the broker. Some brokers have been known to offer anything up to 500:1 leverage, however, 100:1 is likely to be more than enough.
The dangers of leveraged forex trading
A prominent mistake that new traders make is to use leverage with no regard for the risk per trade based on their overall account balance. When there is no concern for the downside risk, leverage can destroy a trading account.
Consider a trader that has a $1,000 trading account and uses a leverage of 100:1. This means that each pip movement is worth $10. Lets say his stop loss is ten pips away from his entry. If the stop loss is hit, then the trader has lost $100 – 10% of the entire trading account, far exceeding the acceptable level of money management.
Limit the dangers with money management
If the correct money management rules are applied, the amount of leverage can become irrelevant.
The reason for this? Traders base their risk on a percentage of their total account balance. In other words, the total amount risked per trade, even with leverage, is less than 2%.
Consider the same trader as above that has a $1,000 trading account and has the same ten pip stop loss. Instead of using leverage of 100:1, where each pip is worth $10, he instead uses leverage of 10:1, where each pip is worth $1.
Now if the trade goes against him by ten pips, this is only a $10 loss – only 1% of the trading account.
By incorporating money management and only risking, you can safely use leverage, because the leveraged amount is less than 2% of the trading capital.
The impact of leverage on transaction costs
Leverage also impacts the cost of forex trading, as each trade costs a certain amount to enter. This is either through a spread or a commission charged by the broker. The more leverage is used, the higher these costs are. The higher the costs, the more profit is required to cover them.
Here is an example to illustrate:
A trader opens an account with $10,000 and decides to buy 10 standard lots of
that have a 2.5 pip spread.
The leverage being used is 100:1 ($10 per pip x 2.5 pip spread x 10 lots). This means, on that particular trade, the cost for each lot is $25 and the trader is buying 10 lots.
The transaction cost of the spread is therefore $250 across all 10 lots, which is 2.5% of the account when the trade has been entered – this does not even take into account the total risk from the stop loss on the trade. The trader has to make a 2.5% profit just to break even on a single trade at the moment of entry.
This is unsustainable and the reason that traders who use high leverage without considering risk or money management tend to lose their entire trading capital.
Compare this with a trader using a leverage of 10:1, where each pip would be worth $1. The cost of each position is just $2.5 ($1 per pip x 2.5 pip spread x 10). This means that the total cost of the trade is $25.
This is much more sustainable and the trader is substantially more in line with money management principles.
So far, you should have learned that:
- leverage is the borrowing of capital to maximise profit.
- forex trading is completed in contracts called “lots”.
- a standard lot is 100,000 units of currency, which means that, using US dollars for denomination, each pip movement is worth $10.
- in order to use leverage, a forex broker requires a minimum amount of capital from the trader – this is called margin.
- different brokers offer different amount of leverage, the most common is 100:1. This means that a trader can open a standard lot with just $1,000.
- when traders use leverage without employing money management, they are in danger of losing their entire trading account.