Understanding Leverage In Forex
Understanding leverage in forex
Leverage is a tool offered by brokerage services to clients that allows them to handle significantly more funds than what they have in their trading account. For example, without any leverage, operating on a 1:1 basis, to control $1,000 worth of an instrument would require a trader to contribute that equivalent.
However, with leverage, one requires far less to control the same amount. Leverage, expressed as a ratio, denotes the relationship between the amount of money in a trading account and the maximum one can trade in a particular market. Trading with leverage is also known as trading on margin. Margin is essentially the required amount to open a leveraged position.
While one has much greater exposure and profit potential from the markets with a smaller deposit, any losses incurred come directly from one’s account, depending on the risk taken. Leverage is capable of magnifying profits and equally magnifying losses as well.
Precautions taken by brokers regarding leverage
A large component of money management is a strategic and risk-centric utilization of position sizing and leverage. For brokers to control their risk, there are several precautions and practices that are in place. While there may be variations of these features, the two main ways brokers achieve this are applying what is known as a margin call and negative balance protection to their clients.
When a trader opens a position, there is a certain percentage of leverage it accumulates based on its position size in relation to the available margin. This percentage consistently fluctuates along with a trader’s floating P&L (profit and loss), also referred to as equity. When a trader has used too much margin below a pre-determined percentage, this event is said to be a margin call, which means the trader runs the risk of blowing their account.
The margin call percentage varies, though on average, margin calls start when the equity falls below 50% or less. This fluctuating figure would be visible as a highlighting of red on a trader’s account tab. At this juncture, the account is at a very high risk of falling to zero, unless they either deposit more funds or close their trades immediately. Once the account is in a margin call, there is a specific percentage (usually 30% or less) where the trading platform automatically liquidates all trades, which is known as the stop out level.
Very much linked to a margin call, negative balance protection is a protective feature offered by many brokers, which ensures that a trading account does not fall below a negative balance, hence the term ‘negative balance protection.’
Leverage in play
Since brokers commonly express leverage as a ratio (1:X format or vice versa), it is useful to understand what these ratios mean in a practical context. Before getting into the nitty-gritty, one needs to also understand lot sizes as this concept, along with margin, is interlinked with getting a good grasp of leverage ratios. A lot in forex is a term that describes the position size equal to either 100,000, 10,000, 1000, or 100 units of the base currency (standard, mini, micro, and nano lots respectively). We show lot sizes as a value up to three decimal places, e.g., 0.553 lots.
With forex, different pairs carry different margin requirements. Not only do traders need to know the minimum and maximum lot size that is possible on a particular pair, but more importantly, they also need to understand the dollar (or other currency equivalent) amount they are risking on an individual trade. Leverage and position size calculators are crucial in this aspect to providing this information accurately without the need for a manual calculation.
Let us assume a trader has successfully opened his/her first live trading account with a deposit of $1000 (margin). They decide to set their account at 1:100 leverage. Now the next logical step for them is to find out, with their $1000 deposit, what is the largest lot size they can open on their favorite pair, USD/CHF. The way to calculate this is by taking 100 (leverage) multiplied by the deposit ($1000), which equals to 100,000.
The 100,000 is the units of the base currency, which is, in this case, USD. As we’ve already established that 100,000 units of a base currency is a standard lot, this means that the maximum position size they can open on this particular pair is one standard lot. Though what does this mean precisely? For a trader to know the monetary amount they can risk in line with the leverage for this pair, they have to know the stop loss size. Assuming they wanted to risk $20 with 19 pips as their stop loss size on USD/CHF, the position size to open here is 0.10, which is the first smallest size below a standard lot (mini lot).
In this case, the equity is going to fluctuate, which would affect the size of other positions within this pair based on the available margin. It’s important to note that the trader may end up unintentionally risking more than planned by increasing their stop loss or disabling it completely, and this will further affect their available margin.
Here is another example which reveals how a trader could risk the same $20 on the same pair (USD/CHF), though with a reduced deposit and much higher leverage. Let us assume that this time, a trader decides to use 1:500 leverage with their broker, but instead of funding with $1000, they can only afford to fund $200. The sum is 100,000 (using the previous calculation), which happens to be the same as in the last instance.
What is different in this case? With fewer funds in a trader’s account and higher leverage, they can also control 100,000 units of the same USD/CHF. So, they are going to be able to risk the same $20 with a 19 pip stop. However, they’d be using up more of their margin because $200 is substantially smaller than a $1000 deposit. Much of the decisions on how much leverage is suitable is a more personal decision than a universal one.
The correct leverage to use is highly subjective as it depends on several factors, such as financial stability and trading experience. Less experienced traders may consider employing less leverage as they tend to be more risk-averse based on their lack of experience. The disadvantage with this idea is one requires far more funds to trade. Inversely, more experienced traders may lean towards higher leverage for the opposite reasons. With higher leverage, one generally does not need as much margin. Even though the leverage is critical, arguably, what is even more so is knowing the dollar amount that a trader is risking on a trade by trade basis as this is the true reflection of what they stand to lose.