Leverage in Forex Trading: Explained
In The Balance’s comparison between stock and forex trading, they mention leverage first because it’s one of the most readily noticeable differences. In the stock market, the typical leverage a trader can use is around 2:1. Brokers in the forex market, on the other hand, can offer up to 400:1 or even more, depending on the region.
But what exactly is leverage and how does it fit into the trading strategies of forex traders?
What Is Leverage in Forex Trading?
Leverage is basically borrowing more funds so a trader can increase their trading position. Brokerages usually lend this additional money on the condition that the trader fulfills the initial margin requirement. This only means that a trader needs to deposit a certain percentage of the total transaction.
The ratio mentioned above refers to how much the trader can borrow in relation to their margin. In the 400:1 example, if the trader is required to put up a margin of $100, then the total transaction value should be at $40,000. This transaction has a margin requirement of 0.25%.
Trading significantly larger amounts than what traders have in their accounts offers a range of benefits. The most notable advantage is the ability to earn huge profits from small movements in the market.
Margin-based Leverage vs Real Leverage
Margin is used to create leverage. Margin-based leverage is calculated simply by dividing the total transaction value by the margin requirement. In the above example, the margin-based leverage is 400:1.
Although this number is useful, it may not always necessarily influence risk. This is because the trader can attribute more than the margin. This is where real leverage comes in.
It is a more accurate indicator of profit and loss. It is computed by dividing the total value of the transaction by the total trading capital in the account. This tends to differ from margin-based leverage since most traders don’t use their entire account’s worth as margin.
Using the example above, if the total value of the transaction is $40,000, and the total trading capital inside the trader’s account is $1000, the trader can trade 10 times with a margin of 400:1.
High Risk – High Reward
Investopedia calls leverage a double-edged sword because it can be extremely profitable while also being very risky. By enlarging the trader’s position, they can enjoy significant profits with minute gains in the market.
In the example above, if the currency pair moves by 100 pips or one cent, the effect will be felt more with the $40,000 position compared to the $100. Depending on which direction the movement goes, this could mean a significant payday or a devastating loss.
More careful traders will opt to use a lower real leverage position to protect their trading capital.
Here’s another example comparing two traders with different strategies. Both traders are trading with a broker that requires a 1% initial margin. They also both have $10,000 each as their trading capital.
Based on their research and market analyses, they both conclude that the USD/JPY currency pair is at a top and will likely go down in value soon. Both traders are now gearing up to short the USD/JPY pair at 120.
Trader X applies a 50-times real leverage on the trade. Based on their trading capital ($10,000), he wants to short the currency pair by $500,000 or five standard lots. One pip of USD/JPY is worth around $8.30 for one standard lot because the currency pair stands at 120.
One pip of five standard lots is worth around $41.50. If the USD/JPY currency pair rises to 121, Trader X will lose 100 pips. This may not sound like a lot, but it represents a loss of $4,150 or 41.5% of their entire trading capital.
The more careful Trader Y, on the other hand, applies just five times real leverage on the trade. In this case, if the currency pair rises to 121, Trader Y will only lose $415.
Although that is still a serious amount, it’s only 4.15% of their trading capital, which enables Trader Y to continue trading longer, despite the loss.
Leverage is an excellent tool for forex trading strategies if the trader is well-equipped with the knowledge to wield it. They have to understand the inherent risk with bolstering one’s position in trading.
Of course, this is not for everyone. Traders who are more passive in their trading may be better off not using leverage.
For more questions about leverage or any other topic related to the foreign exchange market, you can reach us here. You can also try our free demo and start trading today.