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What is Leverage in Forex Trading?

Forex trading or currency trading has been gaining in popularity all over the world. One of the main reasons that forex trading has become so popular amongst retail traders is the availability of leverage.

Leverage allows traders to book large amounts of profit while investing a relatively low amount of money. Without leverage, traders would have to wait for months to see a 10% change in their investments.

Leverage in forex trading is usually provided by the broker. The broker sets the maximum amount of leverage available for a trading instrument from which the trader can choose.

Here is a short guide to leverage in forex trading that will tell you everything you need to know.

What is Leverage?

Leverage in forex trading is a sum borrowed from the broker in order to make a trade. By investing a relatively small amount of money, a trader can hold a very large position in the market.

Leverage is expressed as a ratio. Most forex brokers offer a leverage of up to 1:100. However, the offered leverage can even go up to as high as 1:1000.

The leverage ratio indicates how much capital you’re borrowing from the broker with each trade. For example, if the leverage ratio is 1:100, then you’re borrowing 100 times more capital from the broker than you’re investing yourself.

The presence of leverage greatly increases the potential profit or loss associated with each trade.
For example, if you have invested $10 and the trading leverage is 1:100, then you have effectively invested $1000. Which means that if there is a 1% change in the value of the trading instrument, then you stand to gain or lose 1% of $1000. This amounts to a gain or loss of $10. Since you have invested only $10 yourself, your profit or loss
would be 100% of the $10.

If there were no leverage, then a 1% change in value of the trading volume, would only result in a 1% profit or loss.

The forex market is one of the most liquid markets in the world. This allows forex brokers to offer a high ratio of leverage. Traders can easily enter or exit trades due to the high liquidity and high volume available.

Currency pairs are not highly volatile instruments. They need to be stable so that the markets can operate under stable condition. The movement of currency pairs in the forex market is calculated using pips.

A pip is the smallest amount that a currency can move. A movement of 100 pips in the benchmark EURUSD currency pair would mean that the value of the dollar has changed by 1 cent against the EUR. Since a pip is a very small amount, brokers need to offer leverage in order to make forex trades lucrative for traders.

What is Margin?

The amount of money that the trader needs to invest in order to enter into a trade is known as the margin. The amount of the money that the broker places is known as the leverage.

Every trade has a margin requirement which is decided by the forex broker.

In order to calculate the margin required, you can multiply the total transaction value with the leverage. For example, if you want to trade one Standard Lot of a currency pair with a leverage of 1:100, then you will need to deposit 1% of the total transaction value. This 1% is known as the margin.

The margin required is completely dependant on the leverage being offered. The higher the leverage being offered, the lower the margin required. Hence, if you are trading using a high leverage, then you need to invest a lower amount of money in order to enter into a trade.

The main advantage of margin trading, as mentioned earlier, is that it allows you trade with much higher transaction values compared to the amount of money that you need to invest.

Now, a key distinction needs to be made between real leverage and margin-based leverage. The margin-based leverage denotes the minimum amount of capital that you need to use in order to enter into a trade. However, a trader is free to use more capital if he wants in order to lower his risk.

When a trader is investing capital which is higher than the minimum margin requirement, the real leverage of the trade changes.

For example, if the minimum margin requirement to trade a total transaction value of $1000 is $10, but the trader invests $20, then the real leverage is 1:50 whereas the margin-based leverage is 1:100.

How to Calculate Leverage?

Calculating the leverage associated with a trade is quite simple. Usually, a forex broker will tell you the leverage upfront. But sometimes they only state the minimum margin requirement.

In order to calculate the leverage, you need to divide the total transaction value with the margin requirement.
Leverage = Total transaction value/Margin.

For example, if the total transaction value is $1000 and the margin requirement is $10, then the leverage would by 100/1 or 100:1.

Risk Associated with Leverage

Leverage is known as a double-edged sword, and for good reason. Even though the presence of leverage amplifies your potential profit it also amplifies your potential loss.

For example, if the amount of leverage that you’re using is 1:100. Then the potential profit will be multiplied by 100. But if the price movement does not go in your favour, then your potential loss will be multiplied by 100.

Due to the presence of leverage, there is a higher chance that you can lose your entire capital with one trade. Remember, even though the broker provides the leverage, all the losses and profit that result from a trade are borne by the trader. If you are trading with a leverage of 1:100 and there is a price movement of 1% that goes against your position, then you will end up losing 100% of the capital that you invested.

The greater the amount of leverage, the greater is the risk associated with a trade. This is the main reason that traders need to be very careful when using leverage.

How to Choose Leverage and Minimize Risk?

Since a trader’s risk depends on the leverage, a trader needs to carefully select the leverage that he is going to
use. When a trader is confident about a trade, they can use relatively more leverage and vice versa.

A trader should not always use the maximum amount of leverage that is being offered. They should choose less leverage so that their risk is lesser.

There are several risk management techniques that a trader can use in order to minimize their risk.
Some of the most popular techniques are using stop-losses, investing a low percentage of available capital, and keeping small positions.

Remember that a trader should never invest more capital in the forex market than he is prepared to lose. As a rule of thumb, you should only deposit 10% of your savings into your forex trading account.

Further, a trader should only use a broker who provides negative balance protection. Negative balance protection means that a trader can never lose more money than he has deposited into his account.

Final Thoughts

Leverage should be carefully used in order to maximize profits and minimize losses. The presence of leverage greatly increases the risk associated with each trade. The key to using leverage properly is to understand how it works. We hope that you have found this guide helpful.