Leverage is the use of borrowed money (called capital) to invest in a currency, stock, or security. The concept of leverage is very common in forex trading. By borrowing money from a broker, investors can trade larger positions in a currency. As a result, leverage magnifies the returns from favorable movements in a currency's exchange rate. However, leverage is a double-edged sword, meaning it can also magnify losses. It's important that forex traders learn how to manage leverage and employ risk management strategies to mitigate forex losses.
Key Takeaways
- Leverage, which is the use of borrowed money to invest, is very common in forex trading.
- By borrowing money from a broker, investors can trade larger positions in a currency.
- However, leverage is a double-edged sword, meaning it can also magnify losses.
- Many brokers require a percentage of a trade to be held in cash as collateral, and that requirement can be higher for certain currencies.
Understanding Leverage in the Forex Market
The forex market is the largest in the world with more than $5 trillion worth of currency exchanges occurring daily. Forex trading involves buying and selling the exchange rates of currencies with the goal that the rate will move in the trader’s favor. Forex currency rates are quoted or shown as bid and ask prices with the broker.If an investor wants to go long or buy a currency, they would be quoted the ask price, and when they want to sell the currency, they would be quoted the bid price.
For example, an investor might buy the euro versus the U.S. dollar (EUR/USD), with the hope that the exchange rate will rise. The trader would buy the EUR/USD at the ask price of $1.10. Assuming the rate moved favorably, the trader would unwind the position a few hours later by selling the same amount of EUR/USD back to the broker using the bid price. The difference between the buy and sell exchange rates would represent the gain (or loss) on the trade.
Investors use leverage to enhance the profit from forex trading. The forex market offers one of the highest amounts of leverage available to investors. Leverage is essentially a loan that is provided to an investor from the broker. The trader's forex account is established to allow trading on margin or borrowed funds. Some brokers may limit the amount of leverage used initially with new traders. In most cases, traders can tailor the amount or size of the trade based on the leverage that they desire. However, the broker will require a percentage of the trade's notional amount to be held in the account as cash, which is called the initial margin.
Types of Leverage Ratios
The initial margin required by each broker can vary, depending on the size of the trade. If an investor buys $100,000 worth of EUR/USD, they might be required to hold $1,000 in the account as margin. In other words, the margin requirement would be 1% or ($1,000 / $100,000).
The leverage ratio shows how much the trade size is magnified as a result of the margin held by the broker. Using the initial margin example above, the leverage ratio for the trade would equal 100:1 ($100,000 / $1,000). In other words, for a $1,000 deposit, an investor can trade $100,000 in a particular currency pair.
Below are examples of margin requirements and the corresponding leverage ratios.
| Margin Requirements and Leverage Ratios | |
|---|---|
| Margin Requirement | Leverage Ratio |
| 2% | 50:1 |
| 1% | 100:1 |
| .5% | 200:1 |
As we can see from the table above, the lower the margin requirement, the greater amount of leverage can be used on each trade. However, a broker may require higher margin requirements, depending on the particular currency being traded. For example, the exchange rate for the British pound versus Japanese yen can be quite volatile, meaning it can fluctuate wildly leading to large swings in the rate. A broker may want more money held as collateral (i.e. 5%) for more volatile currencies and during volatile trading periods.
Forex Leverage and Trade Size
A broker can require different margin requirements for larger trades versus smaller trades. As outlined in the table above, a 100:1 ratio means that the trader is required to have at least 1/100 = 1% of the total value of the trade as collateral in the trading account.
Standard trading is done on 100,000 units of currency, so for a trade of this size, the leverage provided might be 50:1 or 100:1. A higher leverage ratio, such as 200:1, is usually used for positions of $50,000 or less. Many brokers allow investors to execute smaller trades, such as $10,000 to $50,000 in which the margin might be lower. However, a new account probably won't qualify for 200:1 leverage.
It's fairly common for a broker to allow 50:1 leverage for a $50,000 trade. A 50:1 leverage ratio means that the minimum margin requirement for the trader is 1/50 = 2%. So, a $50,000 trade would require $1,000 as collateral. Please bear in mind that the margin requirement is going to fluctuate, depending on the leverage used for that currency and what the broker requires. Some brokers require a 10-15% margin requirement for emerging market currencies such as the Mexican peso. However, the leverage allowed might only be 20:1, despite the increased amount of collateral.
Forex brokers have to manage their risk and in doing so, may increase a trader's margin requirement or reduce the leverage ratio and ultimately, the position size.
Leverage in the forex markets tends to be significantly larger than the 2:1 leverage commonly provided on equities and the 15:1 leverage provided in the futures market. Although 100:1 leverage may seem extremely risky, the risk is significantly less when you consider that currency prices usually change by less than 1% during intraday trading (trading within one day). If currencies fluctuated as much as equities, brokers would not be able to provide as much leverage.
The Risks of Leverage
Although the ability to earn significant profits by using leverage is substantial, leverage can also work against investors. For example, if the currency underlying one of your trades moves in the opposite direction of what you believed would happen, leverage will greatly amplify the potential losses. To avoida catastrophe, forex traders usually implement a strict trading style that includes the use of stop-loss orders to control potentiallosses. A stop-loss is a trade order with the broker to exit a position at a certain price level. In this way, a trader can cap the losses on a trade.
Article Sources
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