Forex Leverage: A double-edged sword

Since traders may frequently trade with much bigger leverage than they would with stocks, forex trading draws many more traders than other financial products. Although you may have heard of the term “leverage,” only a few are actually familiar with what it means, how it works, and how it may negatively affect their trading.

Read on for a useful explanation of the advantages of borrowing capital to trade as well as the potential drawbacks of using forex leverage in your forex trading strategy.

What is leverage and how to calculate it

Leverage entails borrowing part of the money needed to place a trade. Money is often borrowed from a broker while trading forex. Forex trading does offer significant leverage in the sense that a trader may acquire and control a big amount of money for a small initial margin requirement.

To determine the leverage based on margin you need to divide the whole transaction value by the margin needed.

The margin required, for example, would be $1,000 if you had to put upfront 1% of the whole value of the transaction as a margin and wanted to trade 1 USD/CHF standard lot, which is equivalent to $100,000. This means that your margin-based leverage is 100:1. If the same calculation is made, the leverage based on margin will be 400:1 and the margin requirement will only be 0.25%.

Forex trading & leverage

Leverage is usually as high as 100:1 in the foreign currency markets. As a result, you may trade up to $100K worth of products for every $1K in your trading account.

Because leverage is an indication of risk, according to many traders, that is why brokers give such high leverage. They would not be offering the leverage unless they were confident that the account would be properly managed and that the risk would also be very easily controlled. The size and liquidity of the forex markets also make it considerably simpler to enter and exit a trade at the desired level than it would be in other less liquid markets.

How to trade forex

In a foreign currency quotation, a pip is the smallest unit of measurement used to track currency changes. In reality, these movements are very small. For instance, when the GBP/USD currency pair moves 100 pip from 1.9500 to 1.9600, the exchange rate changes by merely 1 cent.

To enable these small price changes to be transformed into substantial gains when increased by the use of leverage, currency transactions must be conducted in significant volumes. Small fluctuations in the exchange rate might result in large gains or losses when dealing with an amount like $100,000.

Risks involved when trading with leverage

The problem with leverage is that it may either increase your earnings or decrease them by the same amount. That’s why it is considered a double-edged sword. The risk you take on increases with the amount of leverage you apply to your capital. However, if a trader is not careful, it may have an impact on his or her trading plan. It is important to remember that this risk is not necessarily related to leverage based on margin.

Let’s say we have two traders who both have a $10K trading capital and trade with a brokerage that requires a 1% initial deposit. After some thorough research, they both come to the conclusion that the USD/JPY is at a peak and will eventually decline in value. As a result, they both trade the pair at 120.

By cutting $50K worth of USD/JPY based on their $10,000 trading capital, the first trader decides to use 50 times leverage on this trade. Given that the exchange rate for USD/JPY is 120, 1 USD/JPY pip equals around $8.30 for a standard lot and about $41.50 for 5 standard lots. The trader will have a loss of 100 pips on this trade, or a loss of $4,150 if USD/JPY increases to 121. A 41.5% fall of their whole trading capital will be lost in this one transaction.

The second trader though, decides to use five times leverage on this transaction by reducing $50K worth of USD/JPY using their $10,000 trading capital. The amount of $50K is only equivalent to half of one regular lot. This trader will have a loss of $415 or 100 pips on this trade if USD/JPY increases to 121. His or her loss equals 4.15% of their overall trading capital.

Amount of leverage to use

Traders should select the leverage that they feel most at ease with. Lower levels of leverage, such as 5:1 or 10:1, can be more suitable if you’re careful and don’t enjoy taking risks or you’re still figuring out how to trade currencies. 50:1 or 100:1+ may be suitable to more experienced or risk-tolerant traders.

Final thoughts

Once you know how to manage it, you don’t need to be hesitant towards leverage. Only when you don’t actively manage your transactions should you never use leverage. In any case, with an effective risk management strategy in place, leverage may be effectively employed. Leverage needs to be used carefully but once you’ve figured out how, you won’t need to worry.

Applying less leverage to your trades allows for broader but realistic stops and lower capital losses, giving traders a greater degree of flexibility. If a trade with high leverage goes wrong, it can quickly impact your trading account since you will suffer more losses owing to the larger lot sizes. Remember that leverage may be completely adjusted to suit the demands of each trader.

Disclaimer:

This information is not considered investment advice or an investment recommendation, but instead a marketing communication. IronFX is not responsible for any data or information provided by third parties referenced or hyperlinked, in this communication.