What is leverage in forex trading?
Since the vast majority of forex traders are not able to invest $100,000 in, say, , this is where leverage comes in. Leverage is a form of loan that is backed by your margin, one that allows you to control a position worth many times as much as the initial amount of cash you have invested in a currency.
Leverage is the lifeblood of the forex industry for retail and day traders, which is why it is essential that you know exactly what leverage is and how it works. With that in mind, read on for a complete and comprehensive guide on leverage in forex trading.
Leverage is something that exists in all realms of trading and investment, including in stocks and equities. It is essentially borrowed capital that is loaned to you from a broker that allows you to increase your investment and open a larger position than would be possible if you were relying solely on your own funds.
A typical leverage trade would allow you to deposit $1000 of your own money in a “margin” account, which will allow the broker to front you $100,000 that you can use to invest in a currency pair such as CHF/JPY. This would be a 100:1 leverage trade, as the position you are opening is 100 times larger than the amount of actual capital that you have invested.
As you can imagine, this allows you to greatly amplify your potential gains, as a one-pip shift in a currency pair could instantly translate to thousands of dollars in profit if you have a $100,000 position. Of course, this also means that your losses can be greatly magnified, as tiny price shifts in the opposite direction to what you were hoping for could instantly translate to losses of 100% or more.
It is worth noting that leverage trading in forex is significantly larger and more important than leverage in other areas of the financial industry. For example, leverage in equities will typically allow you to open a maximum position size of 2:1, while futures markets have a cap of just 15:1 leverage. In forex, price movements on assets are typically so small that leverage of up to 1000:1 is often needed just so that profits can actually be realised.
Why is it important to know what leverage is?
It is absolutely crucial to understand what leverage is for a number of reasons. For one, leverage is arguably the only way that a retail trader could possibly expect to make any worthwhile profits. Let’s go through an example in order to better explain what we mean. Remember, standard forex trading is done in lots, with one lot being equivalent to 100,000 units of the base currency in a forex pair.
Let’s say you want to invest in GBP/USD, which is currently trading at 1.3900, in the hopes that the price of GBP will increase and you will be able to sell for a profit. If you invested £1000 worth of your own money without any leverage and GBP/USD moved 100 pips to 1.4000, your profit would only be a few pounds.
However, if you opened a position with 100:1 leverage, that £1000 investment would be worth £100,000. That same price movement of 100 pips up would translate to profits of thousands of pounds, depending on the pip value. Conversely, understanding leverage is also crucial if you wish to understand how much risk you are exposing yourself to.
Let’s say that same GBP/USD trade went in the opposite direction you hoped for. With your leverage position, your losses would be amplified by 100:1, meaning that your entire deposit would probably be wiped out in an instant if GBP/USD decreased by 100 pips.
Leverage can also provide a crucial understanding of how people actually make money on forex markets, since most trades tend to consist of intra-day trades in which prices change by a small fraction of a percentage. With leverage, you can make those small fluctuations count.
What is margin?
In any trade involving leverage, the margin is the most essential component. Put simply, the margin is the “deposit” that you are providing to your broker in order to open up a larger position. Let’s say you are investing £1000 in GBP/EUR to open up a 50:1 leveraged position worth £50,000. You would essentially be “controlling” £50,000 with your initial £1000.
This £1000, which you instruct your broker to take from your forex account and put into GBP/EUR, is your margin. Trading on margin, as they call it, is trading with a leverage deposit in a manner such as this.
With most online forex brokers, the margin is expressed as a percentage amount of the full position you can open. For example, a broker might offer several different types of margin; 0.25%, 0.5%, 1%, or 2.5%. By selecting a 1% margin, you are opening a position worth 100 times as much as the amount of cash you are depositing.
The amount of leverage you choose will determine the trade sizes you are dealing with, as well as the amount of risk and potential profit you are exposed to. Remember, over-leveraging is one of the most dangerous things you can do as a forex trader. Although using huge amounts of leverage can potentially mean massive profits, it can equally mean massive, unrecoverable losses in just a few seconds.
It is therefore essential to be able to strike the right leverage balance that will allow you to pursue worthwhile gains while minimizing your potential losses to a manageable level. All brokers tend to offer different leverages. It is therefore important to do your research and find a broker that offers leverage levels that you are comfortable with.
Let’s walk through an example to better illustrate what we are talking about. Let’s say we have two traders – Trader 1 and Trader 2. Both want to invest in USD/CNY, as they believe the greenback is going to rise in value imminently. Both traders invest $100 in this long position. However, Trader 1 invests $100 at 100:1 leverage, opening a position of $10,000.
Meanwhile, Trader 2 opens a position of 5:1 leverage, meaning their position is worth just $500. In this scenario, both traders were incorrect in their predictions, and USD/CNY dropped 100 pips. Trader 1 would instantly lose all of their deposit, while Trader 2 would lose just a few dollars, meaning that they have plenty left over to fight another day.
Risks and advantages of leverage
As we have covered, trading with leverage comes with its own risks and rewards, making it the ultimate double-edged sword. Let’s break down exactly what the costs and benefits of leverage trading actually are, to help you make more informed forex decisions.
Risks of leverage in forex trading
- Higher leverage means that potential losses can be very high
- Leverage is a constant liability, as all leverage must be paid if you wish to continue trading
- Leverage introduces the risk of margin call (see below), in which your broker will close your trades and liquidate your portfolio if your equity falls below your margin
Advantages of leverage in forex trading
- Leverage can greatly amplify your potential profits from even the smallest fluctuations in the currency market
- Leverage removes barriers to entry and allows you to trade with very low capital
- Leverage does not require any forms of interest to be paid on the loan
If you are going to begin trading with leverage positions, it is crucial that you understand what is meant by a margin call. This is a dreaded term among many traders, as it means you are no longer able to trade or maintain a position. If the amount of money you have in your forex account is unable to cover your potential losses, this means that your equity has fallen below your margin.
At this point, your broker will issue a margin call, meaning that they are asking you to deposit more money into your account to cover potential losses. If you do not do this, your broker will liquidate your portfolio at current market prices and close all of your positions.
Choose Your Broker Wisely
If you are going to begin trading on margin, you need to choose your forex broker very carefully. Leverage in forex trading is a risky business, so you need a broker that can offer a range of possible leverages and will have your best interests at heart. For this, we have got you covered. Make sure to consult our expert UK forex broker reviews to find the right one for you today.