Leverage trading is a powerful tool offered by online brokers and is something that excites Forex traders, particularly new traders. Utilising leverage allows traders to open trading positions much larger than their capital may otherwise allow, thus creating opportunities for greater profits.
Managed correctly, leverage can be lucrative, but it comes with increased exposure to the trader. The bigger the position, the higher the value of small price fluctuations, this is how great gains can be made. It is essential to remember that the increased value also applies to losing trades, and if risk is not managed correctly, unexpected losses can be realised.
In this beginners guide to Forex leverage trading, we will discuss everything leverage related, so that you can take advantage of leverage safe in the knowledge that your position is protected.
In This Article:
- What Is Leverage
- The Link Between Leverage & Margin
- Why Do Brokers Offer Leverage
- Why Do Traders Use Leverage
- Advantages Of Leverage Trading
- Risks Of Leveraging A Trade
- Risk Management
- Summary
What Is Leverage
Leverage is essentially the ratio between how much capital a trader has deposited, and the size of trade that a broker allows that deposit to open. Most speculative traders will open a trading account with an initial deposit between £1,000 - £10,000. Online brokers will offer the option to leverage that deposit to open trading positions anywhere between 10x to 100x the balance of the account.
So, a £10,000 initial deposit placed with an online broker that allows 100x leverage, in theory means that a trader can open a position worth £1,000,000. In reality there are many reasons why this is not a sensible approach as this would be a perfect example of "over leverage" and will be restricted by useable margin.
Leverage is the process of borrowing money from the broker to open the large trade. The broker will take a deposit from usable funds in the form of margin that is a notional transaction and will be repaid when the trade is closed. The relationship between leverage and margin is critical to trading and we explore this further below.
The Link Between Leverage & Margin
Margin is an amount of money that a trader is required to deposit to the broker to take a position. Margin is usually calculated as a percentage of the total trade value, starting at around 3% for the smallest trades and tiered upwards. The level of margin required is determined by individual brokers and you will be able to obtain their margin requirements simply by getting in contact with them.
It is important to remember that whilst it is an attractive to proposition to leverage a position, the margin requirements of the trade will increase in line with the upscaled position. As an example, if you take a position of 10,000 units and the margin requirement is 3%, the margin requirement will be £300, if you leverage your position to 100,000 units then the margin requirement will increase to £3,000.
The purpose of margin is to limit a trader's exposure to incurring unaffordable losses. Whilst margin is not a cost, it is a notional transaction that reduces available funds in accordance with sizes of trades placed. This has the effect of limiting how many positions can be opened without depositing further funds into an account. Lets' say for example that a trader deposits £10,000 into a trading account and takes a position that requires a margin of £2,500. Whilst a cost has not been incurred by the trader, available funds have been reduced to £7,500.
Why Do Brokers Offer Leverage
The opportunity to trade large positions while using only a small level of capital is a major advantage of trading with leverage. It also seems too good to be true and a common question asked by traders is why brokers offer leverage as a trading facility. Of course, there must be something in it for them, and there is!
With the advancement of technology, the number of online brokers is increasing, and the marketplace is more competitive than ever. Leverage is offered by brokers as incentive for traders to choose their trading platform to trade on. They appreciate that not every trader, particularly speculative traders, has the available funds to create the opportunity for worthwhile profits and the level of leverage offered by a broker can be a deciding factor for a trader when deciding which broker to use.
The other reason is that brokers make money on every trade placed by virtue of the spread. Spread is essentially the broker commission fee, charged in the form of commission for placing a trade on the traders' behalf.
» You can find more details on costs of placing a trade with our guide what is spread in Forex trading.
The spread becomes more valuable to the broker as leverage is utilised by the trader, therefore the broker earns more in commission for higher leveraged trades.
Why Do Traders Use Leverage
Forex trading is essentially predicting the value of one currency against the value of another, and capitalising on the price fluctuations between the two. If a trader anticipates that the EUR will grow in value against the USD and is correct, they will profit from the price movement. Price fluctuations when Forex trading are measured in pips, the smallest measurable price movement with a value of £0.0001. Due to the tiny value of the price movements, it is necessary to trade in lots, a standard lot is 100,000 units, a mini lot is 10,000 and micro being 1,000 units.
Obviously, most traders will not have the capital available to purchase 100,000 units of EUR, in fact most speculative traders begin with an account value of £10,000. This is where the brokers assist and offer their traders the opportunity to leverage their forex positions.
All online Forex brokers will offer leverage, levels will vary, but some will allow a position to be taken up to 100x the value of their account. If a trader initially deposits £1,000 to open an account, leverage of 100x would allow a position of 100,000 units.
The purpose of forex leverage trading is to create a trading position that is worth taking. Trading at higher levels increases pip value in accordance with the leveraged trade size i.e., 100,000 units x £0.0001 = £10.
» For more information on pips and calculating their value, see our guide what are Forex pips.
Advantages Of Leverage Trading
Trading with leverage creates three advantages:
1) Free Up Capital
Trading using leverage means that traders can consider entering the Forex markets without using huge levels of capital trade. Without the option of trading with leverage, traders would require capital equal to their investment. If they were looking to take positions that are worthwhile, let's say 100,000 GBP, they would require a capital investment of £100,000. Using leverage, this capital requirement can be as low £1,000.
2) Take Large Positions
Utilising leverage offered by online brokers allows traders with smaller capital investments to take positions that would otherwise be unaffordable. Most speculative traders make an initial deposit into their trading account between £1,000 - £10,000. Using various levels of leverage means that positions can be taken much greater than what the investment may otherwise allow.
3) Maximising Potential Profits
Forex trading is based on capitalising on tiny price fluctuations between two currencies that are measured in pips. As the level of leverage that is utilised increases, so does the pip value, consequently, the tiny price fluctuations have more value. Look at the example below:
This demonstrates the potential gains on a 100-pip gain using varying levels of leverage on a £10,000 investment.
Risks Of Leveraging A Trade
As discussed previously, trading with leverage allows large positions to be taken that may not otherwise be affordable, particularly to speculative traders. As a result, the value of price fluctuations increases incrementally in line with the leverage ratio employed. The obvious risk of leverage trading is that the increase in value of price movements will apply to losses incurred, increasing a trader's exposure to risk.
Let's look at an example:
The above example has been calculated using EUR/USD with a pip value for a standard 100,000 lot size of £8.89. Trader A has a greater appetite for risk and employs leverage of 50:1 which means that they are taking a position of 5x standard lots. Pip value increases in line with the enlarged position and needs to be multiplied as such i.e., £8.89 x 5 = £44.45. Assuming that the position moves against the trader by 100 pips, the loss incurred is £4,445 or 44.45% of the initial investment.
Trader B is more risk adverse and uses leverage of 5:1. The position is half of a standard lot, and the pip value is calculated as £8.89 / 2 = £4.45. For the same 100 pip loss, Trader B incurs a £445 loss or 4.45% of their investment.
Risk Management
Below we discuss briefly some key risk management techniques that can be applied to any form of trading style across any time frame.
Develop A Trading Strategy
A trading strategy sets out the parameters required for a trading position to be taken and exited. It will include details on which technical indicators will be used to identify trading signals along with essential criteria such as acceptable risk and risk to reward ratio's.
» Visit our guide risk reward ratio's when Forex trading.
Acceptable Capital Risk
Forex trading careful management of capital, one of the key fundamental of this to establish what level of capital risk is acceptable. Many professional traders will recommend keeping this at a conservative level, around 1% - 3% of total investment. If an initial investment is made of £10,000, a tolerated 1% - 3% risk level means that no more than £300 is at risk at any given time.
Level Of Risk Per Trade
When discussing acceptable capital risk above, we were calculating risk in terms of total account value. Level of risk per trade is slightly different and is a calculation within total capital risk. Again, let's assume an account with a balance of £10,000 has an accepted risk level of 3%, the total exposure should not exceed £300 over all open trades. If it is defined within a trading strategy that only one open position is allowed at any one time, risk per trade is the same as total capital risk.
If multiple trades are within the strategy, the total capital risk is to be split between open trades. If three trades are to be open at the same time, each trade should have a level of risk equal to one third of total capital risk.
Position Sizing
When it comes to managing risk when leverage trading, the level risk should be identified and the level leverage of taken should mean that the value of maximum pip loss equals the level of accepted risk for the individual trade. Let's look at an example:
In the above example we have shown two outcomes of a leveraged trade, one that is leveraged in accordance with a trading strategy and one that is over leveraged. Assume that a £10,000 account has an accepted level of risk of 3% and the potential pip move against the trade 50pips.
This means that the trade can be leveraged at a rate of 5x. At this ratio, the trade has the flexibility to move the full 50 pips before it reaches the maximum acceptable loss.
The second trade focusing on maximising profits and leverages outside of the range set out in the trading strategy and has a pip value of £60. There are two outcomes here, to remain within the acceptable level of loss, the trade only has a margin of 6pips. If the trade continues to move against the position, losses are beyond those of the acceptable level.
The other outcome is that the trade is allowed to fall the full 50pips, with the increased pip value, this will close at a loss of £3,000!
» See our guide to understanding position sizing and it's impact on trading for more detail.
Place Stop Loss Orders
Stop loss orders are the most powerful tool available in risk management when leverage trading. Referring back to the previous example of a maximum tolerated loss of 50pips or £300, a stop loss order should be placed at this level. If the trade reaches the stop loss level, the trade will automatically trigger and close the trade. It is never enjoyable to lose a trade, but with a stop loss order in place, the loss will always be confined to the parameters set out in the trading strategy.
» See our guide how to use stop loss orders for more detail on protecting your trades.
Summary
Trading with leverage can be a very powerful tool when it comes to generating trading gains, but it does come with risk. The increased positions sizes taken by traders increase the value of fluctuations in price movement, this is great when prices work with the trade, but the risk to losses will also be increased should prices move against the trade. For this reason, it is essential that traders fully understand the risks associated with trading with leverage so that risk management strategies can be adopted.
Leverage is nothing to be afraid of and is essential for most speculative traders. Spend some time researching further and trade with caution until experience and confidence develops. Brokers will offer large levels of leverage, but don't feel obliged to use it all, start small and incrementally increase leverage as you become more comfortable.
