One of the reasons for the popularity of Forex among traders compared to other financial instruments is the possibility of using large leverage. Despite the widespread use of the term “leverage,” only a few understand its true meaning and impact on trade.
What is the leverage?
Leverage allows traders to use borrowed funds to purchase any investment instrument. When trading in the Forex market, borrowed funds are provided by a broker. The availability of large leverage on Forex allows traders to manage significant amounts in the market, having only a small amount of their own funds used to cover margin requirements. To calculate leverage, it is necessary to divide the total transaction amount by the required margin amount.
|Total transaction amount|
For example, if you need to deposit 1% of the total transaction amount, and you intend to operate with one standard USD / CHF lot equal to $ 100,000, the required margin (security) amount will be $ 1,000. In this case, the leverage is 1: 100. Similarly, if the margin requirements are 0.25%, the leverage will be 1: 400.
Margin trading does not always carry additional risks. If a trader has a sufficient amount of own funds, the use of leverage will not necessarily affect his profit and loss. First of all, it is necessary to take into account not the amount of leverage offered by the broker, but the percentage of equity used in trading, that is the actual leverage.
To calculate the actual leverage, it is necessary to calculate the ratio of the total amount of open transactions to the amount of equity.
|The total amount of open transactions|
|Actual Leverage =|
|Amount of own trading capital|
For example, if your trading capital is $ 10,000, and you open positions for $ 100,000 (standard lot), the actual leverage will be 1:10. If ceteris paribus, you trade two standard lots ($ 200,000), the actual leverage will be 1:20.
Most traders refrain from using all their funds in trading, so the leverage provided by the broker is usually different from the actual leverage used by the trader.
Leverage in trading on the Forex market
When trading on the Forex market, traders track price movements in points, that is, in hundredths or ten-thousandths of the value of a currency pair (depends on the pair). However, price movements of a few points are negligible in percentage terms. For example, if the GBP / USD pair rises 100 points from 1.9500 to 1.9600, in fact, the rate changes by only 1 cent.
It is for this reason that it is necessary to use leverage to acquire large volumes of currency pairs and make any significant profit. If a trader operates $ 100,000, a movement of 100 points will bring him significant gains or losses. Forex trading allows the trader to use the actual leverage that corresponds to his trading style, nature, and rules of money management.
The risk of using excessive leverage
The use of leverage proportionally increases not only potential profit but also losses. The larger the percentage of equity involved by a trader in trading, the higher the risk assumed. It should be noted that the actual leverage plays the leading role, not the leverage offered by the broker.
We give an example. Trader A and Trader B each have $ 10,000 in their trading accounts with a leverage of 1: 100. After the analysis, both traders come to the conclusion that USD / JPY has reached its maximum and should fall in price, and take short positions at the rate of 120. Trader A uses the actual leverage of 1:50 and sells USD / JPY for $ 500,000.
Since the current rate is 120, the movement of 1 point for a standard lot is approximately $ 8.30, respectively, the movement of 1 point for 5 lots is $ 41.50. If USD / JPY grows to 121, trader A will lose 100 points, or $ 4150, that is, 41.5% of the capital for one single trading operation.
Trader B is more careful and uses actual leverage of 1: 5.
The amount of the transaction opened, in this case, is $ 50,000 or half of the standard lot. If USD / JPY rises to 121, the trader’s losses will amount to only $ 415, or 4.15% of the total trading capital.
Below is a summary table for the above example.
Using the minimum actual leverage, the trader achieves comfortable trading conditions due to the possibility of installing more distant, but reasonable stops, allowing to reduce possible losses.
Using large leverage can destroy the trader’s account balance in the event of an unfavorable market situation due to a large percentage loss. It must be remembered that the trader himself chooses the leverage in accordance with his needs.
The goals should be reasonable and should not plan to make a million by the end of the month or year by using large leverage.