A question commonly asked by traders is how much leverage should I use? Despite being one of the key advantages of trading the forex market, leverage is also one of the main reasons people lose money trading forex. Understanding leverage and its pitfalls are mandatory to survive the market in the long run. Let us dive deeper into the topic of leverage and see why it is so important to fully understand how this double-edged sword works.
The most common definition of leverage is that “Leverage refers to using a small amount of one thing to control a larger amount of something else”. The use of leverage is something most of us experience in daily life via a mortgage on your house. While you only use a small down payment combined with monthly payments, you are able to control a much larger asset. The same principle is common practice in the foreign exchange markets.
The question is? Can you still trade currencies when the traded amount of capital is superior to your account? The answer is YES, and on top of that: you make a gain or loss over the full amount of the trade, like it was in your account. This leverage principle, permits a trader to control a large amount of capital with a comparatively small amount of capital, is called margin trading.
On the more popular internet sites, webinars or personal talks with rookie traders, leverage is often explained as a tool that will help traders earn money fast and easy. It is true that without leverage, it would be extremely difficult for small investors to accumulate capital while trading the forex markets, but leverage can also be very harmful if not properly understood. There are two sides of the medallion when it comes to leverage, which makes it sometimes difficult to grasp.
Financial leverage is the only way for small investors to participate in a market originally designed for banks and financial institutions. The reason for this is two-folded; one, to help overcome the obstacle of the magnitude of capital required to participate in it. Second, major currencies fluctuate on average less than 2% per day.
It is important to realize that when you conduct a transaction, you are not actually buying all currency and depositing it into your account, this is done by your broker. You as trader are speculating on the exchange rate and make an agreement with your broker that they will pay you, or you will pay them, depending if the trade moves in your favor or not.
When a standard lot of USD/JPY, which equals a value of $100.000, is purchased, a trader does not has to pay the face value in full. Instead the down payment in form of a “margin” is required. For this reason trading with financial leverage is often referred to as “Margin Trading”. Margin is what allows the trading with leverage. Put differently, margin trading can be considered trading with borrowed money – a loan from broker to trader. The initial deposit as collateral for the leveraged amount of $100,000.
When you execute a trade, a certain percentage of the initial deposit will be frozen as margin requirement. How much of a percentage is dependable on the underlying currency pair, current exchange rate and of course the size of the trade. Further details will follow later this article.
How does this leverage work? Let’s start with a basic example and move on from there.
Assume you have bought 1 lot of EUR/USD at 1.1000 and sell it for 1.1200. A trade like this would give a 200 pip profit, which is a 2% return if the whole lot was bought with own funds.
|No. Lots||Value of trade (€)||Margin required (€)||Buy Price||Sell Price||Profit (Pips)||Profit (€)||Percent Return|
If instead we did margin trading, the effect will be significant. A leverage ratio of 1:100 is not uncommon, meaning that for buying one lot of EUR/USD worth of €100,000 you only have a margin requirement of €1,000.
|No. Mini Lots||Value of trade (€)||Margin required (€)||Buy Price||Sell Price||Profit (Pips)||Profit (€)||Percent Return|
Again remember that leverage is a double-edged sword. Meaning that if the trade goes against you the losses are also leveraged. Without strict risk management a trade can easily be whipped out when executing highly leveraged trade. This is the #1 reason why amateur traders lose money.
So far we know that margin is the deposit required to open or maintain a position. When it comes to margins we make a distinction between two types: “free” or “used”. With used margin we mean the amount that is used to maintain an open position. Whereas free margin is the amount left to open new positions. For example when you have a margin requirement to open a position of 1%, and an account balance of $1,000, it means you can open a position worth up to $100,000. Or put differently, a leverage of 100:1.
When you perform margin trading it is possible that you will receive a “margin call” from your broker. Your broker will give you a margin call if your account balance falls below the minimum amount required to maintain an open position. In practice most brokers will automatically close a trade when the margin balance is not sufficient to keep the trade open. With strict risk management a trader should never receive a margin call.
The question remains how do we know how much margin is required. This is automatically shown in most (all) brokerage platforms but let’s take a look at how to calculate this manually. Let’s suppose you are allowed to trade 100:1 leverage from your broker. To figure out the amount of margin to open this position you need to know the current market quote, lot size, and amount of leverage.
(current market quote * volume) / leverage
In reverse quote pairs (having the USD as base currency), the currency denomination is already in USD. Buying a standard lot of USD/CAD at 1.3750, you would need $1,000 margin using the 100:1 leverage ratio. So in this example, when would we get a margin call? It depends on what the balance of your trading account is. When you have a trading account of $10,000 and you make this 1 lot USD/CAD trade, you would receive a margin call if the trade would go negative $9,001 or more. In that situation your position will be automatically closed and you will be left with the remaining $999 as balance.
In equation terms:
IF (account balance) – (value of the trade) < minimum margin requirement
THEN -> Margin call
Another example for a currency that doesn’t have the USD as base currency can be calculated in the same way but with one extra step. If for example, you go long 1 lot of EUR/USD (market quote: 1.1200). This requires:
(current market quote * volume) / leverage = ( 1.1200 * 100,000) / 100 = $ 1120 margin
If this position is opened the broker-dealer will lock the $1120 as used margin. This means that if your account balance would be equal or drop below this amount, your broker will liquidate all open positions on a margin call. So if for example you have an account balance of $10,000 and make this 1 lot trade, you would receive a margin call if the trade would go negative $8880.
Effective Leverage vs. Real Leverage
There is a relationship between leverage and its impact on your forex trading account. The greater the amount of effective leverage used, the greater the swings (up and down) in your account equity. The smaller the amount of leverage used, the smaller the swings (up or down) in your account equity.
To calculate the effective leverage you divide the value of all open positions by the available account balance. So with a position of 1 mini lot ($10,000) and $2,000 in your account, your real leverage is 5:1. A drawdown on your trade of 200 pips would result in your account balance going down by 10%, which equals $200. Due to the drop in account value, the next time a trader experiences a loss of $200, this percentage has gone up to 11%. Indicating that even if positions size is kept the same, the effective leverage rises..
How much leverage you should use is different for each trader. It really depends on what your tolerance towards risk is.
The use of high leverage is a tempting one. Making big profits while only using a small portion of your own money is appealing, but can also let you lose all your money fast. A few safety precautions used by professional traders may help you controlling the risks of working with leveraged positions.
Always use Stop-loss: The use of stop-losses is always important, but extra important in the forex markets. The forex are 24 hours open and a critical event can happen overnight while you are a sleep. Besides the use of stop-loss orders to protect yourself for big losses, they can also be used to protect your profits once a position is trading above your entry level.
Limit your losses: Don’t let your losses get out of hand. Learn to cap your losses to keep them manageable.
Use leverage appropriate to your risk tolerance: Each traders has a different risk tolerance, a ratio of how comfortable someone is towards risks. If you have a low risk tolerance, meaning that you get uncomfortable quickly when it comes to risk, don’t use highly leveraged positions. Don’t use leverage of 50:1 or 100:1 when you are a risk averse trader, better stick to 10:1 or 5:1.