The Forex leverage
Now that we know how pips and spread work, and how we can buy or sell via brokers, we miss to understand how quantities work in Forex market.
For this topic we will go primarily to deepen the concept of forex leverage. Some of the next questions could be: “What type of quantities we use to trade on Forex?” and “How much the pip will be worth based on this quantities?”.
Let’s start from the beginning.
Leverage as a function of the lot
The standard quantity, or the unit of measurement of quantities, with which you trade in Forex is the forex Standard Lot. When you want to buy or sell a particular pair, what you do is to go long or short of a chosen number of lots, on that particular pair.
But how much is one lot in forex? A lot generally corresponds to 100,000 units (one hundred thousand) of the base currency (on the left, at the numerator). So, considering the most important base currency in the world, i.e. the U.S. dollar, a lot will have a value of 100,000 U.S. dollars.
“Does this mean that to trade on Forex I must have an account with at least 100,000 usd to be able to use a lot?!?“.
The answer is obviously NO. There’s no need. Soon I will explain the concept of leverage and margin. Meanwhile, consider the fact that with the evolution and expansion of Forex, in addition to lots, other smaller figures have appeared:
- mini lots, corresponding to 10,000 units, or 1/10 of a lot
- micro lots, corresponding to 1,000 units, or 1/100 of a lot
- nano lots, corresponding to 100 units, or 1/1000 of a lot
So, how much is a pip worth when I will open a transaction with one of these quantities? The calculation is very simple.
If a pip corresponds to 0.0001, just multiply it by the base unit, which is the lot, to find its value.
0.0001 x 100,000 = usd 10 usd.
When I open a transaction with a lot, my pip will be worth 10 usd. With the same calculation:
- mini lots: the pip is worth 1 usd
- Micro lots: the pip is worth 0.1 usd (or 10 cents)
- nano lots: the pip is worth 0.01 usd (or 1 cent)
Obviously, I am not obliged to use a single lot, or just a micro lot at a time. I can simply use the quantities I want. With 3 lots my pip will be worth 30 usd, with 5 mini lots my pip will be worth 5 usd, with 8 micro lots my pip will be worth 0.8 usd, etc.
Forex Leverage according to currency
However, if we want to be more precise, since the value of a pip in Forex refers to a rappot between two currencies, it goes without saying that if this rapport changes, the pip value also can vary:
- Let’s assume the USD / CAD is 1.1030. The formula for the correct value of a pip is: (0.0001 / 1.1030) x 100,000 = 9.06 usd
- Let’s assume that the USD / JPY is 102.70. The formula is: (0.01 / 102.70) x 100,000 = 9.73 usd
In the case of non-dollar base currency (in the numerator), we should add another step obtain always the dollar value.
- Let’s use EUR / USD at 1.2530. The formula is: (0.0001 / 1.2530) x 100,000 = 7.98 eur x 1.2530 = 9.99 usd.
As you can see, the pip value always ends up being around 10 usd. In any case, don’t worry, you will never have to do all these calculations by yourself for trading, there will always be your broker to do them for you and present you the results automatically. In addition, you can easily find on the internet some automated pip value calculator.
However, if you want to practice and discover by yourself the exact values of pips, now that you know the calculations, here’s a useful forex pip value table which shows the number of units per lot according to the pair and the position of the pip:
What is and how forex leverage works
We have seen all the quantities that are used to make Forex trading. The question at this point should be:
“If I want to use a mini lot, should I have 10,000 usd on the account?”.
The answer again is NO. Now we can talk about the concept of leverage.
The famous Archimedes said
“Give me a lever and I will move the world.”
The reason behind this statement is very simple. The lever is a tool that allows you, using a series of basic physics principles, to get great results doing a little effort. Let’s say that we can move large weights using a precise technique with little force.
Forex is one of the many markets where you can use leverage. Speaking about the world of trading and investing, quite simply, the financial leverage is the ability to operate in the markets and move large amounts of capital despite having much less consistent funds.
In other words, the broker acts as guarantor in respect of the market for your operations. So even if you don’t have the required amount in your account to open a specific transaction, the broker will let you open it anyway, because he himself will cover it with the necessary capital.
We will see shortly which are the calculations, but above all what are the guarantees that the broker will ask to allow you to operate with leverage.
Let’s take for example what professional traders and fund managers do. They usually trade with maximum 1 standard lot for each $ 50,000 they have on their account.
So, to think in terms of leverage, the proportion to apply is:
100,000 usd of equivalent on the market, and 50,000 usd of real fund on the account.
$ 100,000: $ 50,000
That is 2:1
According to this example, the leverage with which the professional traders and managers usually operate is 2 to 1. It would be like saying that when they make a transaction in the market, they do it with twice the money they have. This, in practical terms, means that they can achieve, for each transaction, a gain or loss equal to the double of what they could achieve if they would have access only to the capital in their account.
Obviously, for those who know how to do their job well, leverage is a very effective and very powerful tool. We must, however, make a clear distinction, always using the latest example.
Let’s suppose that our trader or manager opens a transaction with a lot, and that this begins to lose. The fact that the broker has guaranteed the market for 100,000 usd does not mean that he will keep the operation open on his behalf until it loses up to 100,000 usd. Absolutely not.
The broker will provide coverage as long as there will be funds on his client’s account, in this case up to 50,000 usd of loss. This is important to understand, because leverage can be a great ally, but also a potential enemy. The important thing is to know what it is and how to use it.
Brokers and leverage today
Most Forex brokers today offer leverage up to 100:1, some even more higher, even 400:1 or 1000:1. Let’s see some calculations with a 100:1 leverage.
100:1 means that I can move a hundred times more than what I actually have on the account. So, with only 1,000 usd on the account I can use a whole lot (1,000 x 100 = 100,000 usd = 1 lot).
To see it from another perspective, always with a 100:1 leverage:
- to use a lot are necessary 1,000 usd
- to use a mini lot are necessary 100 usd
- to use a micro lot are necessary 10 usd
- to use a nano lot is necessary 1 usd
Let’s make an extreme example to make you understand the risks of overdoing with leverage.
Some brokers offer leverage up to 1000:1 (one thousand to one). This way you can use a lot even having only 100 usd on the account. But remember, the pip, with a lot, is worth 10 usd.
If you were to open a position with one lot with only 100 usd on your account (and you can do it, because the leverage allows it), if the price would go against your operation for only 10 pips (consider that in the foreign exchange markets in a few minutes there may be oscillations of hundreds of pips), you would have completely burned out your account.
Therefore, pay attention to leverage. Treat it as an ally, but don’t push it too much, otherwise it will turn into your worst enemy.
But that’s not all. In fact the broker, to allow you to operate with leverage, obviously will ask you some guarantees. In the next lesson I will show you how these guarantees work in a market like Forex.