What Is Leverage In Forex Trading
In this tutorial, you will learn what is leverage in Forex trading.
Using leverage in Forex trading allows you to trade lot sizes and assets of a much larger value than the funds deposited in your trading account.
In most cases, it is because of leverage that you can participate in the currency markets. Without it, the potential to profit would be insignificant unless you invested larger sums to trade larger lot sizes.
Now that you know what is leverage in Forex trading, we will explore the topic further.
By completing this tutorial in its entirety, you will learn;
- What leverage is.
- What margin is.
- What margin levels are.
- The advantages and disadvantages of trading using leverage and margin.
Let’s get started.
What is leverage in Forex trading
The concept of using leverage and margin is probably not as unfamiliar to you as you may have initially thought.
You might understand it already if you have ever purchased real estate. Since most real estate transactions are completed using financial leverage and a form of margin.
I will use this asset class to help me explain what leverage and margin is. You will see the similarities and understand how it works in Forex trading.
Imagine that you want to buy an apartment that is for sale for $200,000. However, you only have $20,000 in savings in your bank account.
In order to buy the apartment, you would have to apply for a loan for the difference.
So you could approach your bank about it and they might be happy to lend you the difference over a 25 year term.
The way this works is, you would contribute say $20,000 as a down payment and the bank would lend you the remaining $180,000. The total amount is $200,000 so you would now have enough to buy the apartment.
By buying the apartment under these circumstances, you are using 10 to 1 (10:1) leverage. Since your down payment is 10% of the total value of the asset and it is being used as margin.
Leverage is just the gearing ratio between the down payment or margin and the total value or price of that asset.
If you had the full amount of $200,000, then you could purchase the apartment without taking out the loan or using leverage. However, this would be the equivalent of trading using 1 to 1 (1:1) leverage. As you have contributed 100% of the assets price.
In either case, you could potentially benefit from increases in equity and make a return on your investment from the full value of the asset. You would also be exposed to the potential losses too, should the asset depreciate in value.
Imagine now that the value of the property increases by 10% or $20,000 and you sell it at a later time for a higher price than what you bought it for.
After repaying the outstanding balance of the loan from the bank, you would be left with a $20,000 profit. This is a 100% return on your margin, since you only contributed a down payment of $20,000. This is excluding any repayments made throughout the term of the loan and purchasing and legal fees.
Without using any leverage, or trading using 1 to 1 leverage, you would have otherwise only made a 10% return on your investment.
The difference is significant isn’t it?
An example of trading forex using leverage and margin
You should be familiar with what is leverage in forex trading now.
But forex is a different asset class to property.
This is because there is no actual loan being made to you and you are not obliged to make any repayments. Since you are not going to be taking physical deliver or ownership of the currency that you will be buying.
You are just speculating on the price.
Instead, you are trading margin for margin or the net difference in the assets price. Otherwise known as a contract for difference (CFD).
Margin is like a collateral deposit required by your forex broker to open and maintain your deals. Any profits or losses from trading will be credited or debited from your balance or your margin deposit.
Forex brokers also allow you to trade using much higher amounts of leverage. This is dependent on the broker and the regulatory jurisdiction they operate in but it can be as high as 500 to 1 (500:1).
This means that you could potentially trade 1 lot ($100,000) with only a $200 margin when using 500 to 1 leverage.
For EU regulated brokers, the maximum leverage allowed is 30 to 1 (30:1). For US regulated brokers, the maximum leverage allowed for forex trading is 50 to 1 (50:1).
This is more than enough in most cases and it does depend on your trading strategy.
Remember, when trading 1 lot, the value of a pip is $10. With a $200 deposit and 500:1 leverage, a 20 pip adverse price movement would be the equivalent of the deposit in negative equity.
That’s not a lot of equity for this lot size and a 20 pip movement can happen very quickly with many currency pairs.
Trading micro lots would be more appropriate with a $200 balance, but this still has its limitations.
Let me explain.
One micro lot is an amount to trade of $1,000.
Using 500:1 leverage would only require $2 in margin from your $200 balance to open the deal.
As $1,000 divided by 500 leverage is equal to $2 in margin.
The value of a pip when trading one micro lot is $0.10. This is a constant regardless of the leverage used.
Therefore, a 50 pip adverse price move from your entry or buy price would result in a $5 unrealized loss. Stopping losses at 50 pips is quite reasonable and can provide enough room for error so the deal can breathe. However, a $5 loss on a single trade idea is equal to 2.5% of your account balance. Which is more towards the aggressive side, especially if you are a beginner.
With a $1,000 balance, a 100 pip adverse price movement is equal to $10 or 1% of your account balance. This is more conservative and a safer way to trade because the relative risk is less. By allowing twice as much room for your deal to breathe, you are also less likely to lose.
The difference between the two is that with the latter example, you are better capitalized and a string of losing trades won’t hurt you as much. With the former example, the probability of getting stopped out of a trade is higher and so is the relative risk.
Even though you are starting with a smaller amount of money in the former, the probability of loss is higher. There are other variables to consider too but everything else being equal, this is the case.
Higher leverage means a lower margin requirement and lower leverage means a higher margin requirement. So less or more money from your balance is being allocated towards margin.
Funds that are allocated as margin are tied up and cannot be used while the deal remains open.
Once the deal closes, any funds allocated to margin will be made available for trading again or for withdrawal. If your deal results in a loss and there is an insufficient balance to debit the difference, it will be deducted from the margin.
Leverage is just a gearing ratio between your deal or lot size and the amount required as margin to open a deal.
For instance, your trading account could be set at 500:1 leverage. This would mean that only $2 would be required to open 1 micro lot ($1,000 deal size).
If you have $1,000 in your account and you trade 1 micro lot, you are in affect trading on 1 to 1 leverage despite the $2 being used as margin. If you traded $2,000, (2 micro lots) with a $1,000 balance, this would be like trading using 2 to 1 leverage.
Simply put, you have enough equity to sustain the deal if the price of the asset (practically) went to zero or devalued by 50%, respectively.
Leverage does not affect the value of a pip.
What leverage is, is like driving a high performance sports car down a two lane street. It allows you to speed up profits (and losses) to potentially get to where you want to go faster. Even though it’s good to have the power to drive faster, doing so under the wrong circumstances or driving in the wrong direction to oncoming traffic will inevitably result in a crash.
How to calculate margin in forex trading
The formula for calculating margin in forex trading is very straight forward and is calculated automatically by the trading platform.
As I have already mentioned above, leverage is just a ratio between your deal or lot size and the margin requirement to open and the deal.
To calculate margin in forex trading, is a simple division between the two for the currency you are buying. Then a conversion may be involved depending on your account base currency in the case that the currency is different.
This is how you would calculate margin;
(Lot size) / (Leverage) = Margin
So in the case of trading 7 mini lots using 30 to 1 leverage, the calculation would be;
$70,000 / 30 = $2,333.33 in margin to open the deal.
If your accounts base currency is denominated in EUR, then the USD amount has to be converted to its EUR equivalent at the current EURUSD rate of exchange.
First, the exchange rate has to be inverted from EURUSD to USDEUR by dividing 1 by the EURUSD exchange rate. If the inverted exchange rate is 1 USD to 0.85 EUR, you would just convert $2,333.33 to the EUR equivalent by multiplying the margin by this.
This is how it would work out;
$2,333.33 x 0.85 = €1,983.33 in margin to open and maintain 7 mini lots.
Forex margin levels
Your forex broker will also have margin levels along with the margin requirement to open a deal.
They determine when you will be notified that your margin is depleting and when your deal will be finally closed.
These are known as a margin call level and a margin stop out level.
- A margin call is a notification, usually sent by email or an alert on your trading platform that your account equity is falling beyond the margin requirement. This happens when the unrealized losses from your open deals causes your equity to fall and reach the amount required to open them. Most brokers have a 100% margin call level. When your equity reaches 100% of your margin requirement you will receive the first notice that your deals may be closed.
Let me give you an example.
You have $200 in your trading account and you decide to open a deal that requires $150 in margin to open it. Should the value of the asset depreciate in value by $50, your equity will be $150 and you will receive a margin call. At this point, you can either top up your account to increase your equity or you can leave it and risk your deal being closed. You can also close the deal yourself to prevent further losses.
- A margin stop out is the closure of open deals to prevent further losses. This is a hard stop enforced by the forex broker when you run low on funds to maintain open deals. Most forex brokers have a 50% margin stop out level. The deals that are losing the most will be closed first and in order to free up margin. If enough margin has been freed to increase your equity, other open deals can remain open until your equity reaches the new margin stop out levels.
If you chose to ignore the margin call as illustrated above, your deal would be automatically closed if or when your equity falls to $75. This is 50% of your $150 margin.
A margin call and a margin stop out can easily occur when trading over leveraged and under capitalized. In other words, when using too large a proportion of your balance as margin.
You can avoid a margin call by risking or exposing only a small percentage of your balance from any open deals.
Ideally, you should maintain sufficient funding in your trading account so you do not get a margin call or a margin stop out.
What is free margin in forex
Free margin in forex trading refers to the amount of money in your trading account that can be used to open deals. If you deposit $1,000 to your trading account, you have $1,000 in free margin to start trading. Once you start opening deals and funds get allocated as margin for them, your free margin will reduce.
Let’s say you open deals that have a combined margin requirement of $500. Your free margin will become $500. You can use this to open new deals or as equity to maintain the existing ones.
Final words on trading Forex with leverage
Trading forex using high leverage is risky.
However, the risks can be minimized by sufficiently capitalizing your account and not over leveraging the balance.
This can easily be achieved by making a sufficient deposit to your brokerage account to support your trading activity. Then by not trading lot sizes that are very high multiples of your balance and only risking a small percentage on your trades.
The value of the pip is dependent on the lot size or trading volume.
Although it is possible to speed up and magnify your potential returns when using higher amounts of leverage. You can also lose money just as quickly and create a lot of damage to your balance when deals go the other way.
Remember, leverage is like a two way street which requires a balanced approach towards risk vs potential rewards.