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The remarkable opportunity to engage in leverage that trading forex traders enjoy represents one of the retail forex market’s chief selling points compared to other financial markets smaller traders can participate in.
Leverage involves the use of someone else’s money to increase the size of your trading position. This position amplification strategy has long been used in the stock and commodity markets, but those markets only allow traders to use considerably lower leverage ratios than retail forex traders can now employ. Read on to find out more about leverage trading in the forex market.
What is Leverage Trading?
Leverage trading means that you amplify the amount of risk you can take with any given margin deposit to establish a larger trading position. The higher the leverage ratio you use, the larger the trading position you can hold in your margin account.
Keep in mind that the more trading leverage you apply to your positions, the more risk you incur. For example, a $100 initial deposit could be wiped out with a small adverse move in the forex currency pair if you use a high amount of leverage. By the same token, if the market responds favorably, then your position’s profits will be magnified by the amount of leverage used when establishing the position.
How Does Leverage Trading Work?
As an example of how leveraged trading works, if you take a leveraged position at a forex leverage ratio of 10:1 with just $100 placed on deposit with your online forex broker as margin, then this will allow you to establish and control a $1,000 trading position.
If you decide to use a higher leverage ratio of 100:1, then that same $100 deposit can let you control a trading position of $10,000, and so on. Always remember that leverage is rather like a double-edged sword since you will amplify both your trading gains and losses if you use it when trading forex.
The amount of leverage you can access in the forex market dwarfs the leverage available in the stock and commodities markets. Depending on the jurisdiction where you live, you may be able to leverage forex positions by as much as 500 or even 1,000 to 1. In contrast, U.S. stocks can only be leveraged at a relatively puny ratio of 2 to 1, and commodities traded on U.S. futures markets can only be leveraged at 10 or 20 to 1.
Leverage vs. Margin
Leverage determines how much you need to put on deposit with your broker to hold a particular forex trading position, while margin is the amount of money that you actually put on deposit with your online broker. You basically employ margin to create leverage.
Leverage is generally expressed as a ratio of the amount of a trading position you can control with one base currency unit. In practice, this ratio looks like X:1 where X is the amount of a position you can control with 1 unit of your base currency. If your base currency is U.S. dollars and your leverage ratio is 100:1, then you can control a $100,000 trading position with just $1,000 placed on deposit as margin.
In contrast to the leverage ratio, the margin requirement of a given position is typically expressed as a percentage. The inverse relationship between leverage and the margin requirement can be seen in the following equation:
Leverage = 1 / Margin Requirement
If you were able to use a leverage ratio of 100:1 at your broker, then your margin requirement would be:
100 = 1 / Margin Requirement
Margin Requirement = 1/100 = 0.01 = 1.0%
You might also want to compute the amount of a position you can control with a given amount of “required margin” or the amount of money you actually need to deposit. You would do this using the following equation to calculate the controllable position size:
Controllable Position Size = Required Margin / Margin Requirement
Using the previous example of a 1% or 0.01 margin requirement and a required margin amount of $1,000 substituted into the above equation, you’d get:
$100,000 = $1,000 / 0.01
This result means you can have a controllable position size of $100,000 if you put $1,000 on deposit as margin assuming a margin requirement of 1%.
Pros of Leverage in Forex Trading
Using leverage when trading currencies has some advantages, including those listed below.
Increased Profits
The main advantage of using leverage in forex trading is that you can control a position that is larger than the amount of money you place on deposit with your broker. If your trades end up being profitable, which is never guaranteed, then your profits will be amplified over those of an unleveraged position by the amount of leverage you used.
Boosts Capital Efficiency
You can use your existing trading capital more efficiently by using leverage since you can control larger trading positions with a given amount of capital to use as a margin deposit. This lets you get started trading currencies with very little initial money.
Combats Low Volatility
The forex market exhibits relatively low volatility compared to some other financial markets, like the stock market for example. Using leverage lets you amplify the impact of movements that do occur on your trading results.
Cons of Leverage in Forex Trading
Using leverage when trading currencies also has some disadvantages, such as those listed below.
Potential for Heavy Losses
Your losses will be magnified by the amount of leverage you use. This turn of events can quickly decimate your trading account, so you’ll probably want to use leverage prudently.
Constant Liability
Leverage involves a constant liability since all leveraged gains and losses must be paid off for you to continue trading in your account after a position is closed out.
Increase Risk of Closeouts or Margin Calls
Using leverage increases the risk of an automatic closeout of your losing trading positions by your broker or of you receiving a margin call from your broker if the net value of your forex trading positions falls below your margin account’s balance.
Master Leverage Trading with These Top Forex Brokers
If you’re interested in trading forex using leverage, then you will want to open a margin account with an online forex broker. Benzinga has taken the guesswork out of finding a reputable forex broker by making the following comparison table of potentially suitable forex brokers that allow leveraged forex trading.
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CedarFX is not regulated by any major financial agency. The brokerage is owned by Cedar LLC and based in St. Vincent and the Grenadines.
Frequently Asked Questions
Q
What leverage should a beginner use?
A
Since beginners tend to make mistakes and might not yet be very good at market analysis, they should probably only trade in a demo account before opening a funded account. This practice lets them develop a trading plan and test strategies incorporated into it in a live trading environment before putting their money at risk. Once they feel more confident in their abilities and have a trading plan with a decent chance of success, then they can elect to start trading in a live account using a moderate leverage ratio of 30:1, for example, to see if their favorable demo trading results will carry over into a live account.
Q
What does 500 to 1 leverage mean in forex?
A
It means that you can control a forex trading position of $500 with just $1 placed on deposit with your broker.
Q
What is the best leverage for $100?
A
The best leverage ratio to use depends on how reliably successful your trading plan is. If your trading plan shows considerable promise, then a 100:1 leverage ratio might be suitable. Not all regulatory jurisdictions will allow retail traders to use that amount of leverage, however, so you might be restricted to using a 30:1 ratio instead.
