Leverage is a very useful tool for online trading, however, it is a double-edged sword especially for those who use it without proper awareness.
In this article we explain everything you should know about leverage before using it. Among the topics you will be able to find:
- What leverage is and how it works
- How margin works
- Useful information on leverage
- Risks and benefits of trading with leverage
Table of Content
What is leverage in forex?
Leverage in forex at its core is essentially borrowing money to invest based on the balance you have in your brokerage account. This money typically comes from the broker and allows you the ability to open an increased size of a position and amplify your holdings without risking all of your own capital.
Naturally, opening these bigger positions will subject you to larger gains but also has the potential to amplify your losses as well. For this reason, it is important you know exactly how to utilize your leverage in a safe way alongside a solid risk management system.
Leverage is mainly used by those trading forex and CFDs, and being a risky tool for traders, it is one of the most debated and regulated topics by financial regulators. In fact, the maximum forex leverage available is not the same for all traders, but varies from 1:20 up to even 1:3000 depending on the broker and the regulation to which the trader should adhere.
How does leverage work in trading?
Once the leverage to be applied to the individual trade has been chosen, one must consider that the leverage will multiply both profits and losses of the trade.
If we consider a standard 1:30 ESMA leverage, with which we opened a 1 micro lot order ($1000 in value), it works as if we were trading with $30000 since it will multiply the initial investment by 30.
For every pip lost or gained on a micro lot, the theoretical loss is $0.10, which with leverage becomes $3.
This means that if the trade goes negative by 100 pips, the trader would lose $300 which is 30 percent of his initial investment of $1000.
What is the relation between leverage and margin?
Margin in trading is the amount of money required to open an order.
When a broker requires a 10% margin, it means that the trader will have to invest 10% on the total value of the investment.
In the case of forex, if the trader wants to open a position worth one micro lot (1,000 units) with a leverage of 1:30, the forex broker will require a margin of 3.33% which corresponds to about $33.
Below you will be able to find the table with the leverage-margin ratio for a generic investment of $1000.
|Leverage||Margin||Margin in USD|
How long can you keep leveraged trades open?
Leveraged trades do not have a time limit. They can be held open indefinitely, but overnight costs must be taken into account.
The longer a leveraged position is held open, the more overnight fees will nibble away at the initial investment.
Is leveraged trading worth it?
Leverage trading is useful for every category of trader, especially for some categories such as scalpers who need to use leverage to make significant profits.
However, using leverage is risky, and before using it one must be aware of all the pros and cons of this practice so as to limit the risks.
To practice you can use a demo account, which through virtual money allows you to trade risk-free using leverage as well.
What are the risks of leveraged trading?
The main risk of using leverage is misjudging an investment, and thus losing more money than invested.
In fact, if we take as an example a $1000 investment with 1:100 leverage, a -5% reduction in the value of the forex pair would be reflected in a -$5000 that would result in the trader having to write off $4000 in losses.
Fortunately, in Europe, Australia, and the UK (but not in other areas), traders have Negative Balance Protection available, which prevents this from happening and whenever the trader risks losing more than he invested, the broker intervenes by sending the account to zero and replenishing the losses out of his own pocket.
Is it possible to trade without leverage?
Trading without leverage is possible if you have enough capital to meet 100% of the margin required by the broker. Il margine richiesto varia in base al volume minimo della posizione (espresso in lotti).
Generally, brokers allow you to open forex positions starting with a micro lot, that is, $1000. However, there are brokers such as FBS (74-89% of retail CFD accounts lose money) that, with their Cent account and high leverage up to 1:3000, allow traders to open positions with just a few USD.
Below we enter the amount of money needed to open a forex position without leverage.
|Lot sizes||Amount of money needed (USD)|
|1 standard lot||100’000|
|1 mini lot||10’000|
|1 micro lot||1000|
|1 nano lot||10|
However, depending on the market and the asset, this figure may be higher or lower.
In the stock market, leverage is often absent, which means having to invest in an entire stock, while for others such as cryptocurrency, it is possible to buy a tiny fraction (even as little as $10) of the virtual currency.
For more information on trading without leverage, check out our dedicated post.
Is it possible to change the leverage used?
The maximum leverage can be changed, but the ability to do so depends on the relevant regulation.
In fact, some regulations provide for the possibility of offering higher leverage for clients who qualify as professionals, that is, who possess a set of requirements such that they prove they know the market and have the experience to handle high leverage.
The regulations that provide for the possibility to change the leverage to a higher one are the following:
|Country/Area||Regulation||Retail leverage||Professional leverage*|
*the leverage for professional traders may change depending on the broker
How leverage affects forex trading
Leverage effectively allows you to control a higher position with less money in your balance. Leverage and access to high leverage within forex trading is generally common. This makes the forex market popular with those who want to trade on leverage.
The value of your leverage will depend on a number of factors, but the lot size is very important. This refers to the minimum quantity of an asset that can be traded and will depend on your broker. A standard lot is 100,000 units of currency, let’s use $100,000 as an example.
The pip is the smallest amount which your quote currency can move. On the US Dollar and many others this is $0.0001 in cash value. The pip value is the effect that this pip change has on your overall amount. Using leverage, your pip value will be increased depending on the leverage amount.
Basically, using leverage greatly amplifies the outcome of your trades whether that means increasing profits, or losses.
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