Understanding Leverage in Forex Trading

Leverage is a tool that allows you to control a trading position with only a fraction of its total value. Effectively, it gives you bigger exposure and allows you to maximize your returns by taking advantage of even the smallest price changes. 

How trading leverage works 

When trading with leverage, a trader will only need to put down a small amount of money to control a much larger position. Most trading providers offer this facility and the extent of the leverage offered depends on the company’s own risk policies as well as the allowed leverage by the local regulator of each jurisdiction.

While some traders enjoy having the extra flexibility, they don’t have to take advantage of all the leverage available on their accounts. In other words, while higher leverage gives you more exposure with a small amount of money, it does not necessarily translate to more risk. It all depends on how you use it and whether your strategy needs the extra leverage or not. For example, day traders may need more leverage given their short-term needs and how they might look for small targets when entering and exiting positions.

On the other hand, long-term traders may not need so much leverage as their targets are much bigger and already translate into bigger returns and profits. In this case, too much leverage may put their account at risk given the larger moves that take place over longer timeframes.

Leverage factors to consider 

Leverage depends on the risk appetite of a trader. The more conservative traders may choose smaller leverage while the ones with a higher risk appetite could settle for higher leverage, regardless if they use it or not.

Furthermore, the market traded dictates the kind of leverage to expect. For example, bitcoin, a volatile trading product tends to exhibit violent price swings. This, in turn, pushed trading providers to only offer smaller leverage to protect themselves and clients against extreme volatility. In most cases, providers are not offering more than 4:1 leverage, meaning traders would need 25% of the value of the position they are intending to open as margin.

Other instruments, such as forex, are available at much higher leverage and as previously explained, this depends on the provider itself and the regulator of that jurisdiction. Leverage can go up 400:1 and maybe even more in some regions yet even the most professional traders do not seek more than 200:1 and that is used as a flexibility buffer instead of a tool to over-leverage themselves in the markets.

Example of leverage

If your account allows 400:1, this means you can control $100,000 with just $250. While this sounds extreme, it’s exactly the kind of flexibility that leverage offers. In this case, a 1% price movement, shown in Figure 1, will generate a profit or loss of $1,000 while without leverage, the profit or loss generated would be $2.5.

Figure 1

What is margin?

Margin and leverage go hand in hand. Leverage is the facility available while margin is the money needed to open a position, regardless of the leverage available on the account. For example, leverage of 400:1 means you can control 400 times more than the amount of money you have in your account. 

If we assume a position worth $100,000, your margin requirement would be $250 or 0.25%. Leverage of 100:1 would translate to $1,000 or 1% as the margin required to control $100,000.

Advantages of leverage 

Broader exposure

The availability of higher leverage means you can create more exposure across a variety of trading products. Keep in mind not to spread your money too thin and to maintain reasonable usage of leverage.

Zero-interest loan

The idea of leverage is like that of a loan except that in trading, you are benefiting from that loan at no extra interest. It’s a completely free facility.

Bigger profits

Bigger exposure means bigger profits if you are on the right side of the market. You no longer have to wait for a large percentage move to make a reasonable amount of money. With leverage, you can make large returns with small price movements. This is especially useful in low volatility conditions where markets are barely moving. As long as you are on the right side of the market, you can still benefit from such minor moves.

Expensive products

Some tradable financial products are expensive in terms of price which means their margin requirements are higher. With leverage, this is mitigated and could allow broader participation. In other words, higher leverage makes expensive trading products cheaper to buy or sell.

Disadvantages of leverage 

While bigger exposure could mean bigger profits, being on the wrong side of the market could see losses magnified just as quickly. It’s important to limit losses and keep leverage under control without over-exposing your account no matter how confident you are in some of your trades. 

This serves as the biggest risk present on accounts with higher leverage and traders should really keep that in mind as it’s easy to be tempted by big profits only to risk it all when seeking one more winning trade.

Example of trading with leverage

A trader is looking to buy gold, believing that the prices have reasons to increase. Assuming the price of gold is $1,800 per ounce, the trader is looking to buy 10 ounces.

The total price of the position would be $1,800 x 10 = $18,000.

While the amount is not very big, most traders have smaller amounts to work with in their trading account. If the account offers leverage of 20:1, the trader would need 5% of the total position as a margin requirement to open and maintain the trade.

In this case, the margin required would be $18,000 x 5% = $900.

A trader only needs to put down $900 to control 10 ounces of gold worth $18,000. A 1% price movement would translate to a profit or loss of $180.

Conclusion

The idea of having leverage allows us to control bigger positions with smaller amounts of money. This has revolutionized the world of trading, especially when leverage is offered for free. This has also given rise to algorithms and other automated systems that take advantage of small price movements while using very big leverage. Of course, this changed the dynamics of the markets but one thing remains certain, you do not have to use all the leverage available. 

Remember that leverage works both ways and should be based on your risk appetite, strategy, and market conditions. If you are a conservative trader attempting to navigate a volatile market, your leverage use should be minimal. If you are a risk-taker trading a rather slow market, you can opt for higher leverage.

Finally, always focus on your returns as a percentage, and the money will follow. Spend time practicing and find consistency and once you do, you can increase your use of leverage to take advantage of a bigger exposure, and in a successful scenario, bigger profits.