What is Leverage in Forex Trading?
An essential element of forex trading is leverage, which may be a potent tool for a trader. You can utilise it to profit from seemingly insignificant price changes, equip your portfolio for more exposure, or stretch your funds farther.
Leverage is a tool that enables you to trade with considerably greater exposure to the market than the initial deposit you made. Leveraged products, like forex trading, boost both your potential for profit and loss.
In forex, leverage is the ratio of the trader’s capital to the broker’s available credit. Leverage, then, is the use of borrowed funds to raise the possible profits. The size of the forex leverage typically surpasses the invested capital by a factor of many. The most popular trading technique is leverage, which will help you better comprehend what Forex trading is all about.
Leverage levels vary from company to company and are based on the trading conditions offered by a particular Forex broker. Therefore, with only his own finite quantity of trading capital, a trader can trade considerably larger quantities than he would. Below we explain the concept of leverage in forex trading.
How does leverage work?
Leverage works by increasing your exposure to an underlying asset by using a deposit, also known as margin. In essence, your provider is lending you the remaining amount while you only put down a little portion of the total value of your trade. Leverage ratio is the ratio of your entire exposure to your margin.
Consider that you wish to purchase one lot of GBP/USD at 1.2860. Since one lot of GBP/USD is equal to $100,000, $128,600 would be needed to purchase the underlying currency without using leverage. Your trade is now worth $128,800 if GBP/USD rises by 20 pip to 1.2880. You would have earned $200 if you closed your position.
You would have lost $200, or less than 1% of what you paid for the currency pair, if the market had gone the other way and GBP/USD had plummeted by 20 pip.
Alternately, you may have started your trade with a provider who offered leverage and required 10% margin on GBP/USD. In this case, you would only need to spend £100, or 10% of your exposure of £1000, to initiate the trade.
You would still make $200 in profit even if GBP/USD increased by 20 pip, but at a far lower cost.
Of fact, if the GBP/USD exchange rate dropped by 20 pip, you would still lose $200, which would be a worse loss than your initial payment.
Different types of leveraged products
The majority of leveraged trading involves the use of derivative products, which means that rather than really holding the underlying asset, you trade an instrument whose value is derived from the price of the underlying asset. This is the situation in forex trading, where you reach an agreement with a provider to trade the price difference between the opening and closing of a position on a currency pair.
Leverage can be utilised in markets other than forex, such as stocks, cryptocurrencies, and indexes. Leverage is frequently used by traders in the cryptocurrency market to boost the liquidity of their funds. Trading other decentralised assets, for example, allows traders to better utilise their assets by using leverage to maintain the same position with less collateral.
What is a leverage ratio?
The leverage ratio compares the entire exposure of your trade to the required margin. Depending on the market you are trading, the people you are trading it with, and the size of your position, your leverage ratio will change.
In the prior example, an investment with a 10% margin would have the same exposure as one with a 10% margin and a £100 investment. As a result, the leverage ratio is 10:1.
In order to safeguard your position from sudden price changes, leverage is frequently offered at a lower level for underlying markets that are more volatile or less liquid. On the other hand, more liquid markets like the forex might have leverage ratios that are especially high.
Higher leverage ratios may be found while exploring leveraged trading services, however applying too much leverage will hurt your positions.
Benefits of using leverage
As long as you are aware of the risks and how leverage works, it may be a very effective trading instrument. Here are just a few advantages:
- Even though trading hours differ from market to market, some markets, like the forex and cryptocurrency markets, allow for round-the-clock trading.
- Magnified profits: You simply need to invest a small portion of the deal’s worth in order to make the same profit as in a typical trade. Margin can boost your gains on profitable trades, but it can also multiply your losses on losing one because rewards are computed using the whole value of your position.
- By employing leveraged instruments to bet on market movements, you can profit from both rising and falling markets by shorting the market. Going short is the phrase for this.
- Gearing is the capacity to raise the amount available for investment. Utilising leverage can free up money that could be invested elsewhere.
Drawbacks of using leverage
Although forex trading and other leveraged products provide traders a number of advantages, it is crucial to take into account any potential drawbacks. Here are some important things to think about:
- Your provider could ask you to contribute additional funds to keep your trade open if your position shifts against you to the point where your margin requirements exceed your net account capital. This is a margin call, and to lower your overall exposure, you’ll either need to raise funds or sell assets.
- Because your initial investment is relatively lower than in conventional transactions, it might be simple to forget the amount of capital you are putting at risk. Margin trading magnifies losses as well as rewards. In order to limit your risk, you should think about your trade in terms of its whole worth and potential downside.
- Leveraged trading entails basically borrowing money to open the entire position at the expense of your initial deposit, which is known as funding charges. You will be charged a small fee to cover the costs of keeping your position open overnight if you want to do so.
Trading with leverage can be risky because losses could be more than your initial investment, but you can utilise risk-management methods to lower your potential loss. One well-liked method of lowering the danger of leverage is the use of stop-losses. If the price moves in the opposite direction, putting a stop-loss on your bet can limit your losses.
Markets move quickly, though, and some circumstances can prevent your stop from being activated at the price you’ve specified. You can minimise risk using a variety of other tools, including as price alerts and limit take-profit orders.
How do I Choose the Best Leverage Level?
It is difficult to determine which is the right leverage level. This mainly depends on the trader’s trading strategy and the actual vision of upcoming market moves. The most popular leverage in Forex is 1:100.
While stationary traders frequently use low leverage amounts, scalpers and breakout traders frequently utilise high leverage since they typically seek out quick transactions. Just remember that Forex traders should select the leverage amount that they feel most comfortable with.
To settle for a high leverage is risky, although it might look like an attractive option. For those traders who are new to online trading and just wish to employ high leverage in the hopes of making significant profits while oblivious to the fact that the experienced losses will also be very great, leverage in the forex market may present extremely serious problems.
How do I Manage Leverage Risk?
Leverage can thus boost potential earnings while also having the potential to increase prospective losses. You should be careful when deciding how much leverage to use on your trading account. Though trading in this fashion necessitates careful risk management, it should be noted that many traders always use leverage to boost their prospective returns on investment.
Avoiding the detrimental effects of Forex leverage on trading outcomes is very doable. First off, opening a position with the maximum trading volume, or trading the entire balance, is not a reasonable course of action.
To manage the leverage risks properly, we recommend using trailing stops, keeping positions small and limiting the amount of capital for each position.
Calculation of Leverage in Forex
Measuring leverage for trading is not difficult to do and the formula below can be used.
- Leverage = 1/Margin = 100/Margin Percentage
For example, if the margin is 0.02, then the margin percentage is 2%, and the leverage = 1/0.02 = 100/2 = 50. You can even use your margin calculator to calculate the amount of margin used.
Pros and Cons of Leverage
You can do more with less
May increase investment returns
Access to Higher-Value Stocks
Improved capital management
Margin calls and liquidation
Interest charges on borrowed funds
Limited risk management
No income generating instruments
Once you understand how to manage leverage, there is no reason to be afraid of it. Applying less real leverage to each trade allows for broader but realistic stops and lower capital losses, giving traders more breathing room.
If a highly leveraged trade goes wrong, it can quickly wipe out your trading account because you will suffer greater losses due to the larger lot sizes. Keep in mind that leverage is completely variable and may be tailored to the needs of any trader.
Leverage should never be employed if you let your transactions run their course without your involvement. Otherwise, with correct management, leverage can be used effectively and productively. Leverage must be handled carefully, and if you do, there’s no need to fear.