Utilising leverage when trading Forex markets is commonplace, but many traders are still uncertain what leverage trading is and when it should be used. Leverage is the practice of borrowing money from a broker to take a position that would otherwise be unaffordable.
Using leverage can increase the opportunity for larger profits, but it also comes with risk if not properly managed. Therefore, it is essential that traders understand the pro's and con's of using leverage within their trading strategy to maximise opportunity and minimise risk exposure.
This guide discusses when should leverage be used by traders.
In This Article:
- Definition Of Leverage
- Advantages Of Leverage
- Leverage And Risk Exposure
- When To Use Leverage In Trading
- Summary
Definition Of Leverage
Leverage is essentially the ratio between a trader's capital balance and the size of position that is actually taken. Online brokers offer varying levels of leverage up to 1:100, meaning that a small account with a deposit of just £1,000, can take a position 100x that size. The difference is made up from borrowing directly from the broker.
Leverage is a necessary tool for many traders to make trades of value. 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 brokers assist and offer traders the opportunity to leverage their forex positions.
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 with leverage creates three advantages:
1) Free Up Capital
Trading using leverage means that traders can enter 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 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.
Leverage And Exposure To Risk
Trading with leverage increases the value of price fluctuations, obviously this increases the value of potential gains, but it also increased the potential losses. 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.
When Should Leverage Be Used
Given that leveraging a trade increases trading opportunities, while at the same time increases a trader's exposure to risk, perhaps one of the most common questions asked when discussing leverage is when when should leverage be used when trading?
Leverage should only ever be used to maximise gains and therefore should only ever be utilised when a trading opportunity has arisen where the advantage is clearly on the trader's side.
Prior to trading, time will have been spent drafting a well written trading strategy that sets out market conditions that act as trading signals, along with risk and reward ratios. Only when a trading opportunity meets the criteria set out in the strategy, and where pip risk can be quantified, should leverage be used.
» See our guide to risk reward ratio's when Forex trading.
Let's assume that a trading opportunity has arisen and the perceived risk if 50 pips. The capital is £10,000 and tolerated risk is not to exceed 3% of account value I.e., £300. Once this has been established. leverage can then be utilised at a ration equal to £6 per pip.
This is how leverage should be used, conservatively and in line with a trading strategy that sets out the tolerated levels of risk.
Summary
Using leverage when trading Forex markets is bit of a double-edged sword. It is necessary to take large positions and generate gains of value, but equally, increases a trader's exposure to risk. A common question asked by new traders, keen to minimise their exposure, is when should leverage be used? The answer is simple, when the odds are in the trader's favour!
Using leverage is not anything to be scared about, so long as the risks are understood, mitigated and in line with a trading strategy. When using leverage, it is necessary to act conservatively, forget about making unrealistic profits and concentrate on leveraging at a ratio that matches risk and reward ratios.
