Forex trading leverage explained

Most new traders start with small account sizes to get familiar with the market, develop their trading strategy, and get trading experience. However, trading with a small account size of a few hundred dollars can act as a major obstacle if you want to increase your profits. Especially on the Forex market, where currency pairs usually don’t fluctuate much on a daily basis, and traders can feel as though their account is going nowhere even if they have a few winning trades in a row.

Fortunately, there’s a solution to increase your returns on winning trades – it’s called trading on leverage. And in this article, we’ll explain everything you need to know to start trading on leverage, what leverage means on the Forex market, and how to magnify your trading performance with your next winning streak. An understanding of leverage will make a huge difference to your bottom line.

How does leverage work in the Forex market?

Most of the time, currencies fluctuate less than 1% per day unless there is some significant and breaking news which could increase market volatility to a large extent. Forex brokers have found a solution for this and nowadays offer opportunities to trade on leverage to all of their clients. First things first, let’s define leverage in Forex trading.

Forex trading leverage allows you to place a much larger position than your initial trading account size would allow. Basically, your broker is lending you their money to open a larger position size, and takes a part of your trading account as collateral for the trade. This collateral, called the “margin”, is returned to your account after you close your leveraged position. This definition for leverage is widely accepted among traders and best describes its meaning in Forex trading.

You may be asking yourself, where does the broker’s money that is used to trade on leverage come from? Most Forex brokers have agreements with various investment banks or other financial institutions that lend the money to the Forex broker based on special conditions, which is then used by the broker to lend the money further to their clients. It’s important to note that spreads, which are the broker’s profit, also increase when you open a larger position size, and leverage increases not only your profits, but also your losses. That’s why you need to be cautious when trading on extremely large leverage.

Leverage and margin requirements

So far, we’ve explained what the meaning of leverage in Forex trading is, but as a Forex trader, you can choose the amount of leverage you want to trade with. Forex brokers usually offer leverage ratios of 10:1, 20:1, 50:1, 100:1 or even higher, which depend on the broker's regulation and legislation. Your Forex account leverage determines the total position size that you can take on the market.

1

Let’s say you choose leverage of 100:1 and have a $1,000 trading account size – this means that your maximum position size would be $1,000 x 100 = $100,000, i.e. you could trade with a total of $100,000 while having only $1,000 deposited in your account! In the following table, you can see how the total position sizes that you can take change with different leverage ratios.

Leverage ratio

Margin used as $

Total position size

1:1

$1,000

$1,000

2:1

$1,000

$2,000

10:1

$1,000

$10,000

50:1

$1,000

$50,000

100:1

$1,000

$100,000

200:1

$1,000

$200,000

400:1

$1,000

$400,000

 

Depending on the leverage that you use, your broker will allocate a portion of your trading account size as collateral for the leveraged trade. This is called the margin, and the following table shows how much margin you need to put aside depending on the leverage ratio.

Margin-based leverage ratio

Margin requirement as %

of total position value

1:1

100%

2:1

50%

10:1

10%

50:1

2%

100:1

1%

200:1

0.5%

400:1

0.25%

 

As you can see, with a 400:1 leverage ratio, you would need to put aside only 0.25% of your trading account size to open a leveraged position. This is done automatically by your broker, so you don’t have to worry about calculating the margin yourself. When your leveraged trade hits your profit target or you choose to close it manually, the margin will be automatically returned to your trading account.

Forex leverage: Example scenario

So far, we’ve covered what leverage is in Forex terms, so let’s see how it can work to your advantage. Leverage and margin may sound complicated at first, so let’s take an example to make these concepts crystal clear. Let’s say your trading account size is $1,000.

Here is an example of Forex trading without leverage. The total position size you could take without leverage would be capped by the total amount of funds you have in your trading account, i.e. $1,000. In Forex terms, where a standard lot equals a position size of 100,000 units of the base currency, $1,000 represents a micro lot. Without digging deeper into details, a one-pip move on a standard lot represents around $10 of profit or loss, which means that one pip on a micro lot represents roughly $0.10, or 10 cents, of profit or loss.

2

If you take a long position on EUR/USD and the pair goes up 100 pips, your total profit without leverage would be around 100 pips x $0.10 = $10, or 1% of your trading account size. Since most currency pairs usually don’t fluctuate more than 1% per day, it would be a very difficult task to grow your trading account without leverage, even if you get most of the trades right.

Here is an example of Forex trading with leverage. Let’s take the same example, but this time with  leverage of 100:1. With a $1,000 trading account size, the total position size you could take would be $100,000, or one standard lot. A move of 100 pips in this case would represent a profit/loss of around $1,000, or 100% of your trading account size! Compare this with the example of trading without leverage, and you’ll see why so many traders are attracted to the Forex market’s high leverage.

However, there’s something important that you have to bear in mind – taking the example above, your entire $1,000 trading account would be taken as the margin for the trade, as you’re opening a $100,000 position size on a 100:1 leverage ratio. A problem would arise if the trade went against you, even by one pip. Your trading account would fall below the required margin, and you would receive a so-called “margin call”, which will be discussed later in this article.

Margin-based vs real leverage

By now, you’ve learned what leverage means in Forex. However, there’s a difference between your real leverage, and the margin-based leverage that takes your entire trading account size as collateral for the trade. Your real leverage depends on your leverage ratio and the position size that you’re taking.

For example, if you’re trading on a 100:1 leverage ratio with a $1,000 account size, you’re not required to open a $100,000 position size. In fact, that is absolutely not advisable, and was only used as an example of how leverage works.

To respect your risk management, you would likely have to take much smaller position sizes than the total position size that you’re able to take. Let’s say you want to open a $10,000 position size on EUR/USD, with the value of one pip roughly around $1. With a $1,000 trading account and a 100:1 leverage ratio, you would only have to put aside $100 as the margin for the trade ($100 x 100 leverage = $10.000 position size), and $900 would be left as so-called “free margin” which is used to withstand any negative price fluctuations. You’re still able to make a good profit, but without taking on too much risk.

What is a margin call?

A margin call occurs when your free margin falls below the margin requirement for your leveraged trade, or multiple leveraged trades. When we were speaking about the real leverage that you use on your trade, we said that a part of your trading account is put aside as the margin with the remaining part acting as your free margin. This free margin can be used to open additional leveraged trades or to withstand negative price fluctuations on existing leveraged trades. If your trades go against you and your free margin falls to zero, you’ll receive a margin call from your broker. This means that all your open trades will be closed at the current market rates, and all you’ll have left in your account is the initial margin that was used to open those trades.

It's important to closely follow the amount of free margin at all times, so you can prevent a margin call (by closing some positions, for example) if your free margin starts to fall.

Final words: Forex leverage explained

In this article, we’ve explained what leverage ratio stands for and how leverage can be used to grow your returns. An understanding of leverage is vitally important to your success, but be aware that it not only increases your profits, but also your losses. The term leverage can also be divided into margin-based leverage or real leverage.

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