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What is Leverage in Forex?
By Stjepan Kalinic , Updated on: Apr 07 2023.
Leverage in forex is the ratio between the money on your account balance and the maximum position your broker is allowing you to take, in other words, it’s a method used by forex traders to amplify their trading capital and maximize their potential profits or losses while trading with less capital.
Forex leverage is a tool that best fits in small bottles. It is like medicine – responsible use can be a saviour, while abuse can lead to total ruin. Therefore, leverage should be used in moderation.
This guide will give you an overview of leverage in forex and how to use it responsibly. Here's what we'll talk about:
- What is Leverage?
- How does the Forex market work?
- Props of Using Leverage
- Cons of Using Leverage
- Example of Using Leverage in Forex
- Leverage and Margin - What are the differences?
- Dosing Makes the Difference
- Frequently Asked Questions
What is Leverage?
In layman's terms, leverage is the ratio between the amount of money you have in the account and the total size of positions the broker allows you to take.
You are using leverage every time you enter a position whose nominal value is larger than the balance of your account. This ratio can vary a lot. It usually depends on the financial instrument, but it can be imposed by the regulatory agency licensing the broker.
For equities, this can be only 2:1, but for forex, this can go to 500:1, or even higher.
How does the Forex market work?
While not as nearly as present in the financial media as some other markets, the forex market dwarfs almost any other in the world.
It is a network of global banks and financial institutions, operating in a decentralized way, 24 hours a day, 5 days a week. The trading session starts with the Australian market opening on Monday and lasts uninterrupted until the U.S session closes on Friday. This is very different from stocks that trade only for a limited time each day.
Although it is prime ground for speculators, the forex market is essential for facilitating global trade, with the volume of daily transactions exceeding US$6 trillion.
Props of Using Leverage
Despite risks, leverage does bring some advantages to the table.
- Magnified returns: The biggest temptation of high leverage is amplifying returns. It allows you to create disproportionately large returns with modest sums. This can be useful in periods of low volatility when the market movement slows below the average.
- Smaller upfront investments: If you are fully invested and unleveraged – you can use the margin for a new low-risk opportunity. This, of course, requires some investment savviness and solid risk management skills.
Cons of Using Leverage
Leverage obviously has its drawbacks. Some are obvious, while others are hidden.
- Magnified losses: Avoiding losses is impossible. Every single trading strategy will eventually experience a loss because the market is simply too unpredictable. When extremely leveraged, losses can be disastrous, if not fatal, for the account. Therefore, if losses make you emotional and throw you off the risk management plan, you might consider limiting or even avoiding the leverage.
- Higher fees: It might not be obvious to beginners, but commissions that you pay are proportional to the size of your position. If you are trading a lot, using high leverage might cause the fees to add up quickly, eating into your profits.
- Temptation: The possibility of high returns can be very tempting and lead to overtrading. Naturally, this causes higher fees and increases the risk of experiencing a magnified loss.
Example of Using Leverage in Forex
Let us imagine you have 2 accounts at 2 different brokers, each with $10,000. Broker A is a regulated broker, restricting you to use „only“ 30:1 leverage. Meanwhile, broker B is an offshore broker, allowing you to use leverage as high as 200:1.
While doing research, you spot an opportunity for selling EUR / USD, anticipating that the value of the U.S dollar rises against the Euro.
You sell at the price of 1.15, using 10% of your available funds. The following matrix table shows what happens when EUR / USD falls to 1.145, or if you are wrong and it rises to 1.155.
| Broker A | Broker B |
|---|---|
| 10% margin = 3 x $10,000 = Lot size 0.3 or $3 per pip | 10% margin = 20 x $10,000 = Lot size 2.0 or $20 per pip |
Now let's check the potential scenarios:
| Scenario 1 (win) | Scenario 2 (loss) |
|---|---|
| Broker A = 50 pips x 0.3 lots = $150 | Broker A = - 50 pips x 0.3 lots = -$150 |
| Broker B= 50 pips x 2 lots = $1000 profit | Broker B = - 50 pips x 2 lots = -$1000 |
However, novice traders often forget that the fees will be much higher when using high leverage. For example, for trading 0.3 lots, you will likely pay anywhere between $1.5 and $3 in commissions, while 2 lots will cost you anywhere from $14 to $20 – depending on the pair you trade.
Furthermore, there are much worse consequences for using excessive leverage in case of a loss. For a $150 loss, the capital falls to $9,850 - requiring a 1.5% gain to break even.
For a $1000 loss, the capital falls to $9,000 - requiring an 11.11% win.
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Leverage and Margin - What are the differences?
The difference between the leverage and margin is only in the point of view. We express leverage as a ratio and margin as a percentage.
For example, unleveraged (cash) accounts equal a margin of 100%. It is not possible to enter into a larger position than your balance. Meanwhile, a 2:1 leverage equals a 50% margin, while a 10:1 leverage equals a 10% margin.
Having a low margin requirement allows you to use high leverage, but that doesn’t mean you should. You can simply trade at a smaller size, according to your risk management plan.
Dosing Makes the Difference
In many ways, leverage is just like poison – the matter of dosage. It can be a medicine in small amounts and help you grow a modest account into a meaningful one very quickly. But losing control and using too much will lead to an inevitable crash.
The catch 22 is that you shouldn't trade large accounts without experience, but without experience, it is hard to produce meaningful returns with a small account. At the start, it can often feel like wasting time, but seasoned traders understand that it is actually a rite of passage.
In this situation, it is essential to cultivate healthy trading habits from the very beginning. Setting hard rules, using trading journals, and taking breaks are some tools that beginners can use with great success.
Frequently Asked Questions
What is a good leverage ratio for forex?
There is no consensus about a good leverage ratio, but one could consider regulatory guidelines.
In recent years, some of the most prominent regulators worldwide, like The Commodity Futures Trading Commission (CFTC) in the U.S, or European Securities and Markets Authority (ESMA), have restricted the max leverage to 50:1 and 30:1, respectively.
While experienced traders might use bigger ratios, we'd advise using 10:1 leverage at most through the first year of trading for beginners.
Is leverage good or bad?
Leverage is an amoral concept. It can do both good and bad, depending on its use. Yet, the temptation to pursue unrealistic returns for many traders causes them to abuse leverage.
Even if they are successful, this might encourage them to indulge in leverage even more. Eventually, a single mistake can completely destroy their account, or in some cases, the entire investment business. For example, Archegos Capital Management collapsed in March 2021, erasing $20 billion in value due to excessive use of leverage.
