Traders can use leverage to magnify their market exposure with a smaller capital investment. While it can enhance returns, it also heightens risk, necessitating careful risk management.
Leverage can directly impact financial exposure to navigate the volatile currency markets effectively. This is what this article is going to talk about.
What is leverage in forex?
Leverage in forex trading refers to borrowing money from a forex broker to open a position in the market. With leverage, you can put only a fraction of the full value of a position with your broker lending you the rest of the amount you need. The leveraged money is then used by the trader to hold a larger position in the market.
Earned profits and incurred losses are based on the entire trade’s movement, which is why leverage is often referred to as a double-edged sword in trading. Therefore, it's important for forex traders to learn how to manage leverage and mitigate risks to minimize losses.
What is leverage trading?
Leverage trading involves using borrowed funds to amplify the size of a trading position, allowing traders to control a larger position size with a smaller amount of capital. It magnifies both potential gains and losses.
It is commonly used in various financial markets, including stocks, commodities, and forex.
How does leverage trading work?
You can use leverage with any size of account balance. But it depends on the leverage ratio and margin of your forex broker.
The leverage ratio is the amount of your fund in relation to your broker’s credit size. It shows how much a trade can be magnified with the margin by the broker. The margin required by a broker depends on the rules and trade size of the exchange house.
If the margin requirement is 1%, traders will be required to hold at least 1% of the total trade amount as a margin. The leverage ratio for this sample trade is 100:1. This means that for every $1,000 deposit, you can trade $100,000 worth of currency pairs.
To better understand leverage trading and how it differs from traditional forex trading, lets us look at an example:
You open a position at USD/EUR for $5,000.
Traditional Forex trading requires traders to put in $5,000 in the market upfront. Any profits earned or losses incurred would be made by blocking the sum of $5,000 in the market. If the price moved up by $20, you would earn $20 on top of your $5,000.
When you use leverage, the investment amount you put in is substantially low. For instance, if the leverage is 10%, you can enter the same market position by only investing 10% of the total amount $5,000, which is $500. Even though you opened a position with only $500, you can still get the same amount of profits or losses that you would receive in a $5,000 position.
Benefits of leverage trading in forex
Market shorting
With leverage, you can speculate market movements and benefit from both rising and falling markets. So when the market is bearish, you can go short to profit from the dip. Once you sell, you can buy an asset back at a lower price to widen the gap between the high selling price and the low buying profit. This way, you don’t risk too much of your account despite a falling market.
Magnified results
Leverage trading multiplies your returns whenever a trade is successful, as profits are always calculated on the full position. However, one must be cautious as this can also magnify losses. If a trader opens a position and the market reverses, the incurred loss would be greater than the sum of their capital.
Diversify your portfolio
Using leverage enables you to free up a huge chunk of your capital to invest in other markets. And if you are not looking to diversify, leverage trading is an ideal way to achieve greater market exposure.
Types of leverage ratios
Debt-equity ratio
The Debt-Equity Ratio is calculated by dividing a company's total debt by its total equity. This ratio offers insights into the balance between debt and equity in a firm's capital structure. A higher ratio suggests a greater reliance on borrowed funds, potentially increasing financial risk and vice versa.
Equity multiplier
The Equity Multiplier, also known as the financial leverage ratio, is computed by dividing total assets by total equity. This ratio indicates the proportion of a company's assets funded by equity. A higher equity multiplier implies a higher degree of financial leverage, meaning a greater reliance on equity to finance assets and vice versa.
Degree of financial leverage (DFL)
The Degree of Financial Leverage (DFL) assesses how changes in earnings before interest and taxes (EBIT) impact a company's earnings per share (EPS). It is calculated by dividing the percentage change in EPS by the percentage change in EBIT. A higher DFL implies a stronger impact of EBIT changes on EPS, indicating a higher degree of financial leverage and vice versa.
Consumer leverage ratio
The Consumer Leverage Ratio is determined by dividing total household debt by disposable personal income. This ratio offers insights into the level of consumer indebtedness by comparing total household debt to the income available for spending. A higher consumer leverage ratio may signify increased financial strain on households, potentially affecting consumer spending and overall economic stability.
How much leverage should you use when forex trading?
The appropriate level of trading with leverage in forex is subjective and varies based on individual risk tolerance, trading strategy, and experience. While higher leverage can amplify potential gains, it also increases the risk of substantial losses. Many financial regulators impose limits on leverage to protect traders.
Common leverage ratios include 50:1, 100:1, or 500:1, but using high leverage requires caution. Traders are advised to assess risk tolerance, employ risk management strategies, and consider lower leverage levels to mitigate potential downsides.
Trading with leverage: How does this work?
Choose a leverage ratio
Select a leverage ratio based on the risk tolerance and the broker's offerings.
Decide capital allocation
Decide how much capital one wants to allocate to a trade.
Calculate position size
Use the chosen leverage ratio to calculate position size. Multiply capital by the leverage ratio to determine the total value of the position one can control.
Understand amplified gains and losses
Leverage magnifies both potential gains and losses. The gains are amplified if the market moves in the trader's favor. Conversely, if the market moves against them, losses are also magnified.
Maintain margin requirements
Maintain a margin, which is a percentage of the total position size that one must keep in their trading account. This serves as a security deposit to cover potential losses.
Implement risk management
Set stop-loss orders to limit potential losses. Determine the maximum amount of capital to risk on a trade. Effective risk management is crucial to protect one's trading capital.
Be mindful of market volatility
Leverage becomes more impactful in volatile markets. High volatility can lead to rapid and significant price movements, affecting positions.
Adhere to regulatory limits
Understand and comply with regulatory limits on leverage. Different regions have varying restrictions to ensure responsible trading on leverage practices and protect traders from excessive risk.
Unleveraged forex vs leverage forex trades: What's the difference?
Capital requirement
In unleveraged trading, traders use only their own capital to open a position. If they want to control a position worth $10,000, they need to invest $10,000 of their own money.
However, with leverage, traders can control a larger position size than their actual capital. If they have $1,000 and use 50:1 leverage, they can control a position size of $50,000.
Position size
The position size is directly tied to the amount of capital one has in unleveraged forex.
However, forex leverage allows traders to control a larger position size.
Gain and loss magnification
Gains and losses are directly proportional to the market movement in unleveraged forex. If the market moves 1%, the gain or loss is 1% of the invested capital.
On the other hand, forex leverage magnifies both potential gains and losses. If the market moves 1% and one's using 50:1 leverage, the gain or loss is 50 times the market movement.
Risk exposure
The risk is limited to the amount of the invested capital in unleveraged forex.
Leverage trade in forex increases the risk significantly. While it amplifies potential returns, it also exposes traders to higher potential losses, sometimes exceeding their initial investment.
Margin requirements
There are no margin requirements in unleveraged forex beyond the amount one's willing to risk.
On the contrary, trading leverage in forex involves maintaining a margin, a percentage of the total position size, as a security deposit. If losses approach this margin, a margin call may be issued.
Risks associated with excessive leverage
- Loss of entire capital: Excessive leverage raises the risk of losing the entire invested capital quickly. A few unfavorable market movements can wipe out the trader's account, especially when the leverage level is high.
- Margin calls: High leverage raises the risk of margin calls. If losses near the margin requirement, brokers may demand extra funds. Failing to meet a margin call can trigger automatic position closure at a loss.
- Overtrading: Excessive leverage may encourage overtrading as traders try to recover losses quickly. Overtrading increases transaction costs and the overall risk exposure, compounding the negative effects of leverage.
- Increased emotional stress: Large, swift losses create overwhelming psychological stress. Traders facing significant drawdowns from excessive leverage may impulsively make fear-driven decisions, worsening their losses.
Use leverage to diversify your portfolio
Trading forex with leverage allows you to deposit only some percentage of the total trade value. This gives small capital traders freedom to explore larger markets with the hopes of reaping large profits. However, one must be well-informed about the challenges and risks involved before using leverage in trading.
