12 mins read
You’ve probably come across the term leverage, at least once. It has a variety of descriptions and in trading, is referred to as the credit given to a trader by their respective brokerage company –a middleman who acts as a bridge between a trader and the financial markets– to enable them to open large positions which would otherwise yield profitable returns.
Often associated with margins, which refer to the funds used as collateral before leveraging. Leverage trading can either take you to the bank or send you home packing. To fully capitalize, you need to understand how leverage works and how it relates to margin works.
There are two sides to the coin and in this article, we’ll look at them both and determine whether or not using leverage is crucial to one’s trading success.
Leverage In Forex Trading
As mentioned, leverage in foreign exchange markets is the amount of money a trader is credited by his/her brokerage company to assume a larger position. Say, for example, a trader has $500 in their account and wants to open a position on an asset worth $1000. What happens? Since the trader wishes to trade on leverage, the respective brokerage company will offer an extra $500. Now, the initial $500 in the trader’s account has become $1000. So if the trader opens a position with $1000, $500 worth of personal money, and $500 borrowed, and exits the market with a profit of $2000: This is x4 return on investment.
Now, the aforementioned example is just to familiarize you with the concept of leverage trading. In real-time, leverage is expressed as a ratio. To illustrate; assume you have $100 trading capital but wish to magnify your potential returns. You find out that your broker offers a leverage of 100:1; meaning that for your every $1, your broker will multiply it 100 fold. So, your $100 in the account is now leveraged and you can take up positions of up to $10,000. Interesting right?
Leverage Ratio Calculation
To fully understand leveraging trading, you should be able to work out various calculations and establish your strategy effectively. Most, if not all, brokers provide tools that can aid in these summations. You will find margin calculators and the like, but the majority of these calculations can be done off the top of your head.
So how is the leverage ratio calculated? Simple. Given the ratio 100:1, the smaller value (1) refers to the money already deposited in your account, and the larger value, is the measure of how much (x100) the broker will magnify your deposit. So a $10 deposit with leverage of 100:1 will be $1,000.
What Is Margin
Margin is the amount of cash a trader must have in their account to facilitate a leveraged trade. To borrow from the above-mentioned example, the $100 that you started with in your account before leveraging is now what is referred to as the margin. This amount varies depending on the brokerage company, and there are always certain requirements in place to ensure the margins remain favorable.
Here is a simple formula you can use to determine the margin:
Cost of position / higher value in the ratio = Margin
- So if our imaginary trader wishes to trade $50,000 with a leverage of 100:1, then the margin will be;
$50,000 / 100 = $500
So when doing your purchase on margin, the required deposit will be determined by the leverage being offered, and by –of course –the broker’s terms and conditions. After you make this purchase, it is referred to as the initial margin from which you can now leverage.
Leverage Vs Margin
By now you should already be able to tell the difference between leverage and margin. If don’t worry, let’s dig deeper. The two terms, often used hand-in-hand, have varied meanings that complement each other. Margin offers the exposure and leverage magnifies this exposure. In simpler terms, the margin is the amount of capital in your account needed to open a position and leverage is the multiplying factor that amplifies the magnitude of your margin. If you have $50 (margin) in your account and wish to open a position on an asset, say at $500; a leverage of 10:1 will make this possible.
To further expand on this; if a trader has taken on too much risk, the broker company can place them on a margin call or impose a stop-out. Here is a detailed explanation of these two concepts;
- Margin Call – In this scenario, a broker will demand that extra funds be deposited to fulfill the minimum value requirement. This is if the trader’s current balance and potential profits/loss equal the margin requirement.
- Stop-out – A stop-out comes into play when your equity is less than half of the required margin. Here, all your trading positions risk automatic closure as a result.
The aforementioned concepts depict how margin relates to leverage.
Risks involved in Forex Leverage
Now that you are familiar with the term leveraging, you should also understand the risks associated with it and the countermeasures you can put in place to mitigate these risks. One mistake that traders often make is looking for get-rich-quick schemes in the financial markets. Another, even more, grave mistake is trying to use leverage trading as a get-rich-quick tool. It is no secret that 99.9% of all ‘ways to get rich in 24 hours or overnight’ are scams targeted at the feeble-minded. Based on this, leverage trading should be done carefully, and with this staggering profits will follow.
Leverage can either make or break the bank. The more leverage you apply to your capital, the more the profit; and the risk too. So what are the risks involved in leveraged trading that a trader should know? Let’s find out;
- Market volatility – Leverage can be greatly affected by market volatility given that the foreign exchange market is very liquid. Understanding this risk and how to overcome it is pivotal for the success of any trader.
- Overleveraging – Using just the right amount of leverage gives you control over your trading experience and eventually your profit/loss ratio. An excess in the amount of leverage is directly proportional to risk.
- Margin levels – Ideally a trader should be careful not to deplete all their available margin. It is good practice to only use one’s leverage when the markets are undoubtedly in your favor. This way you can keep your margin levels intact and still make a profit.
- Several pips – A closer look at the amount of risk associated with the number of pips could go a long way in determining just how much loss a trader can incur. Each move of a single pip should therefore be calculated and the results measured against capital. It is common practice for this loss to be no more than 3% of total trading capital.
Minimizing Risk When Leverage Trading in Forex
We have already established the risk one faces when using leverage to trade forex. Now let’s look at what you can do to minimize this risk. As you seek to increase your profits, be weary of your potential losses too. Below are some of the tools that can assist you in your efforts to mitigate the risks associated with leverage trading in forex;
- Negative Balance Protection
A highly effective tool that can come in handy when the market conditions are unfavorable. The negative balance protection tool cushions your account from running below zero equity. What does this mean? When the markets move against your trades, your account will not read a negative irrespective of the losses you incur. This tool will keep you afloat and prevent your account from going bad to worse.
- Stop-Loss Order
A stop-loss order is a very useful tool that all traders should take advantage of. A stop-loss will ensure that your open positions are closed when you hit a certain amount of losses. Usually, a trader will gauge the number of losses he/she can take and set the stop-loss order to come into play for when the said losses accrue. A crucial tool is necessary to minimize risk when trading with leverage.
- Take Profit Orders
Always take profit when you can. Don’t be greedy! This is one unspoken rule that traders often understand as soon as they blow their equity and are left in the trenches by the markets. Financial markets, forex to be specific, are very volatile. You could be amassing considerable profits one moment and the next your account could be flat.
In leverage trading, the same risk applies too. To overcome this, you should have target profit amounts in your trading strategy and make it a habit to cash out each time you attain these levels. A take-profit order will automatically close your positions in the market once a certain value (which you preset) is reached. This is a must-have risk prevention tool when trading with leverage.
Used in unison, the above-mentioned tools will go a long way in helping you manage the level of risk associated with leverage trading. If you are a newbie trader it is advisable to start trading with smaller amounts and gradually increase over time. Not only will this improve your trading experience, but you’ll also master effective ways to carry out sustainable trades.
Merits and Demerits of Using Leverage
As is with any other tool involved in forex trading, leveraging has its ups and downs. Choosing whether the pros outweigh the cons is a personal choice and should be done meticulously should you want to venture into the markets. Let’s take a deep dive into the differences;
Merits
Here are some of the top advantages of using Leverage when trading forex.
- Leverage trading allows you to buy unaffordable assets and benefit from investing in them.
If, for instance, you had a balance of $100 in your account and you wanted to trade an asset –say silver- at $1000. Without leverage, this would be impossible. But, with leverage of 100:1, you could easily open a position of $1000 and trade the said asset. So yes, leveraging allows you to buy unaffordable assets.
2. You will get better profits trading with leverage than without.
It is common knowledge that higher risk equals higher returns, and leverage does just that: It helps you earn more profits with a relatively lower account balance. An open position of $100,000 will no doubt accrue more interest than a position of $1,000.
3. Access to Additional Funds
No explanation here. Having extra funds is automatically an advantage be it in real life or financial markets. To expand on this, leverage trading will guarantee extra funds in your account which could be used to gain more exposure in the markets. This is a step up as opposed to having little to no funds in your account. Remember, with more funds, you can also withstand market volatility more easily.
Demerits
Just as we mentioned earlier; two sides to a coin! Here are the disadvantages of leverage trading in forex;
- Bigger and more devastating losses.
Now, we have mentioned that leveraging will increase your purchasing power of assets and allow you to assume large positions in the market. This automatically translates to better profits when you exit the market as planned. But if your trade does not go as per your strategy, just as the profits were bound to be magnified, so will the losses. If you had an open position of $100,000, down from $1000 thanks to leveraging, and it drops to $95,000; this means you are down 500%. In the end, not only do you lose your starting capital, but you also end up with an extra debt of $4,000.
2. Margin Calls
Another disadvantage of leveraging trading is margin callswhichares often an aftermath of incurred losses. Here you will be called upon by your broker to deposit more funds and fulfill the minimum value requirements for continued leverage trading. In this event, a trader will have one of two options, deposit the additional funds to cover the losses or liquidate available assets held in their account.
It should be noted that without prior knowledge, forex leveraging can prove to be a destructive tool. To quote business mogul Warren Buffet: “When you combine ignorance with Leverage, you get pretty interesting results.” I think this sums it up.
When Is It Too Much Leverage?
Ideally, leverage trading is a wise strategy; or maybe it isn’t. Depends on how you apply it. In the world of finance, you should know what your account leverage ratio is and the returns you are poised to get. Remember, the higher the returns, the higher the risk. And with more risk, even greater responsibility to avert it. With this said, let’s assess just how much leverage is too much leverage. We’ll use illustrations;
Assume Trader X and Trader Y both have a starting capital of $1,000 and they decide to go long on an asset, say USD/EUR. Now both of them have agreed that USD/EUR, now at 20, is bound to hit a top and further rise in value so they apply leverage, individually.
Trader X, a relatively newbie trader, goes for a 500:1 leverage on the trade which means his long position on USD/EUR now sits at $500,000 (500 x $1,000). Now if the market moves against Trader X’s long position, say to $450,000, it will represent a greater loss in their trading capital compared to Trader Y, who was careful and only went for a 50:1 leverage. This is just but an instance of too much leveraging.
Final Thoughts: Using Leverage in Forex Trading
So is there a need for leverage use when trading forex? Based on the above information, there are two answers to this highly-asked question: Yes and no. Yes, if you are well versed with the applications of leveraging and can confidently use it to capitalize on your returns; and no if you are unfamiliar with leveraging and lack the proper knowledge to handle market volatility within this type of forex trading.
If you have learned the technical know-how comprising leverage trading, you shouldn’t be afraid to jump into the market and make your profits. Leverage trading, with a hands-on approach, can prove profitable. Consequentially, if you would rather trade using your cash and avoid interest on borrowed funds then leverage trading is not for you.
