What is a good leverage in forex?

If you have ever considered or read about online trading, you have likely come across the term ‘forex leverage’.

Upon further research, you may have started to wonder whether forex leverage is a good or bad thing – on the one hand, many traders seek to obtain the highest amount possible yet there are negative connotations as far as risk is concerned.

You may then wonder if it is best to go as high as possible, find a middle ground, or perhaps just scrap it completely.

An experienced trader will have very likely asked themselves all the above questions at some point in time, and found a formula that works best for them.

What is leverage and how does it work?

Leverage allows a trader to open positions without fronting the full amount required for the units traded.

At first, this may sound counterintuitive since nothing in the world of finance comes for free, however, if we remind ourselves of what trading CFDs means, the principle will begin to make sense. CFD stands for ‘Contract for Difference’ and the key is in the word ‘Difference’.

When you open a Kopen of verkopen position for let’s say 1,000 units of an asset, you are not purchasing the asset. You are simply stating that you believe the asset will move in a certain direction and are hoping to profit from the change in the asset’s value multiplied by 1000 units.

A broker agrees to pay you if your prediction comes true. Your profit or loss comes from the difference. The moment you open a trade, the difference is 0, therefore your profit/loss is also 0.

At this stage, neither do you owe the broker any money, nor does the broker owe you. It is only when the price starts to move that the profit/loss also moves.

So, what leverage does is the following. Rather than having to provide all 1,000 units worth of margin to open a position, the broker agrees to allow you to provide a fraction of it and open the position all the same.

Every time the price moves in your favour, your account balance is credited with the corresponding profit and every time the price moves against you, your account balance is debited.

When the trade loses by more than the available balance in your account, it simply closes.

So theoretically speaking, a CFD broker could require you to provide 100% of the margin or no margin at all, and the result would be the same; you’d still profit or lose by the amount traded.

Example 1: No leverage – Full margin required

Trader 1 wishes to buy 1,000 units of asset X whose price is $1 per unit. With no leverage, they must provide margin of $1,000 to open a position.

They have $2,000 in their account; therefore, they can open the trade.

After opening, the asset’s value falls from $1 to $0.98 incurring a loss of $20. The account balance is now $1,980. In this example, even if the asset’s value moves all the way to $0, there would still be $1,000 left to spare in the balance.  

Example 2: Infinite leverage – No margin required

Trader 2 wishes to buy 1,000 units of asset X whose price is $1 per unit. With infinite leverage, they are not required to provide any margin.

They have $20 in their account and open the trade. The value of the asset falls from $1 to $0.98. The trade incurs a loss of $20, therefore the position automatically closes leaving them with a balance of 0.

Example 3: Some leverage – Some margin required

Trader 3 wishes to buy 1,000 units of asset X whose price is $1 per unit. Their forex broker allows 1:100 leverage, and they have $200 in your account. 1:100 leverage means only 1/100^th of the full margin needs to be provided, which in this example would be $10.

After opening the trade, the asset’s value falls from $1 to $0.98. The trade is losing $20 while $180 remains in the balance.

The balance will only be depleted if the trade remains open while the price falls to $0.80.

So, what is the best leverage – High, Low, or Medium?

What should have been concluded from the above examples was that leverage did not directly affect how much was won or lost. In all cases, despite varying leverage, the trader lost $10 each time the asset’s value dropped by a cent.

When the price fell to $0.98, in all three examples, $20 was lost. Why? Because in all examples, the same quantity (1,000 units) of the same asset (X) was traded at the same price ($1).

The only thing forex leverage dictated was how much margin was required to open the trades.

In the first example, Trader 1 was trading without leverage or, equivalently, forex leverage of 1:1 and had to provide $1,000 margin with $1,000 to spare for other trades.

However, if he’d had 1:100 leverage available like Trader 3, he would have only had to have used $10 and had $1,990 to spare for other trades.

In the second example, the trader had infinite leverage and decided to trade an overly large volume relative to his small balance.

With a small fluctuation in price, the remaining balance disappeared, without giving him the chance to profit if the market produced a potential comeback.

So, both these extreme examples show that on the one hand, high leverage offers traders more options to work with, but it is up to the trader to handle these options responsibly.

Don’t forget spreads and commissions

The above examples were all set in a world without spread and commissions. But in reality, all forex brokers apply either one or the other.

In case you didn’t know, spread assigns two prices to an asset. So, in the previous examples, asset X, rather than having a single price of $1 per unit would more likely have something like $1.01 and $0.99.

That price difference is called spread and it means that although a trader buys at $1.01, the value upon opening is $0.99 creating an immediate loss of $0.02 per unit.

If the spread for asset X was indeed $0.02, then Trader 2 would have lost his entire balance to spread, simply by opening the trade and incurring an immediate $20 loss.

All three traders would face the same spread. Commissions work similarly by applying a set fee per unit or lot.

Summary

There are pros and cons to different forex leverage levels. High leverage allows traders more room for manoeuvre and can be used to diversify their trading portfolio.

At the same time, they may get carried away and trade too large relative to their account balance (margin level). Low leverage, whilst making margin requirements higher, does have the benefit of moderating risky behaviour.

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.