The opportunity to leverage a trading position is hugely attractive to many traders. Leverage allows traders with a small level of initial investment to take large positions that would otherwise be unaffordable. Used sensibly, leverage trading can create large gains, but it is not without risk.
Many traders see the potential for large gains using leverage and blindly take large positions without considering the dangers of over leveraging an account. Consideration should be given to maintaining useable margin, exposure to large losing positions and prematurely triggering stop loss orders.
In This Article:
- What Is Leverage
- Why Do Traders Use Leverage When Trading
- Dangers Of Over Leveraging An Account
- Reduced Useable Margin
- Exposure To Large Losses
- Triggering A Stop Loss Order
- Summary
What Is Leverage
Leverage is the ratio between how much capital a trader has deposited into their online trading account, 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 leveraging an account and will be restricted by useable margin.
Essentially, leverage is the process of borrowing money from the broker to open the larger trading position. 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.
Why Do Traders Use Leverage When Trading
Forex trading is the practice of predicting the value of one currency against that of another, and capitalising on tiny 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.
Dangers Of Over Leveraging An Account
One of the most common mistakes made by beginner traders is to jump straight into trading, blindly take advantage of maximum leverage in anticipation of making huge sums of money very quickly. Many traders will win their first trade by good fortune alone and will continue to use maximum leverage. Trading in this manner without any consideration or knowledge of the dangers of over leveraging an account, will soon fail and leave a trader with a large, unexpected loss that can potentially wipe out their trading balance.
Below we discuss the three main dangers of over leveraging an account:
Reduced Useable Margin
Margin is an amount of money that a trader is required to deposit to the broker in order to take a leverage trading 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.
If useable margin falls below the requirement of the broker they may issue a margin call, which is the liquidation of all open positions. This meaning that every open position is closed regardless of whether they are profitable or in a loss making position. This is extremely dangerous as it crystallises losses, and can wipe large amounts of capital from a trading account.
» For more on this read our guide what is a Forex margin call.
Exposure To Larger Losses
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.
Triggering A Stop Loss Order
Another danger of over leveraging an account is that losing trades can still arise even if price action is correctly predicted. The reason for this is that stop loss orders are prematurely triggered. It is very rare that price action will swing into a winning position as a trading position is taken. It is always wise to allow for some risk, the level of risk allowed will be determined by an individual's trading style and appetite to risk, but it is widely suggested that no more than 1% - 3% of trading capital should be risked.
Let's take a 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 before the stop loss order is triggered is 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 triggering the stop loss. When the stop order is activated, the trader is automatically closed at a loss of £300 and meets the criteria of acceptable risk set out in the trading strategy.
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, the stop loss can be set so that the trade will close within the accepted level of risk, but this will happen within a 6-pip move. This is almost certainly going to prematurely trigger the stop loss order before the trade has the opportunity to move into a profitable position.
The other outcome is that the stop loss order is placed at 50pips, however, with the increased pip value, this will close at a loss of £3,000!
Summary
Trading with leverage can be a powerful tool for traders with smaller accounts. Large positions can be taken that would otherwise be unaffordable, creating opportunities for larger gains to be made. It is essential however that traders are fully aware of the dangers of over leveraging an account, as large and unexpected losses can quickly be made. Being aware of the risks of leverage, and utilising risk management strategies will mean that trading with leverage is nothing to be scared about.
