The textbook definition of leverage is having the ability to control a large sum of money using none or very little of your own money and borrowing the rest. In Foreign Exchange markets and in financial markets in general, leveraged trading is defined as an act of using borrowed money from a forex broker to increase earning potential.
To put it simply, leverage trading, which is also known as margin trading, is essentially borrowed money provided by a Forex broker to get involved in potentially high-profit trades in the forex market without having to invest vast swathes of your own capital. $50,000 for a $50,000 investment. This is called 1:1 or no leverage.
Fortunately, it is now 2022 and when you are trading forex you’re not leveraged 1:1, you’re leveraged anywhere from 3:1 all the way up to a forex leverage ratio of 500:1. But what are the crucial factors you need to know about leverage in forex trading?
How does leverage work in forex trading and how do you know what is the right leverage ratio for you when trading forex?
Fun fact: Forex trading was traditionally reserved for society’s elite who could afford to come up with large amounts of capital and required a high initial investment. Traditionally, $50,000 had to be invested as a starting trading capital.
The first thing you need to know is how to use leverage in forex trading. Let’s take 100:1 leverage as an example… A forex leverage ratio of 100:1 means you can trade a notional value 100 times greater than the capital in your trading account. So now, you simply have more money in your trading account, and you have the ability to basically, leverage your currency trading. For example, to control a $50,000 position, your forex broker will set aside $500 from your account and you can control $50,000 with $500. This means that with a leverage ratio of 100:1, you need to meet a margin requirement of just 1% in your forex account.
But with great power comes great responsibility… Let’s take the GBP/USD currency pair as an example…
Without leverage in forex trading, opening a 1 lot trade (100,000 units) would require a trader to invest around $127,000. Using a leverage level of 500:1, we can dramatically reduce the amount of capital required.
$127,000 / 500 (leverage used) = $254.00 required capital
Using this leverage size, we can use a simple formula to calculate leverage and to work out the amount of invested capital needed:
Buy trade: Ask price x contract size/leverage ratio
Sell trade: Bid price x contract size/leverage ratio
1 lot = 100,000 contracts (contracts worth is based on the base currency which in our case is GBP)
Keep in mind, however, that although leverage is mainly associated with forex trading, many online brokers also enable traders to use leverage when trading CFDs. This means that not only you can use leverage when trading the forex markets but also when trading CFDs such as commodities, stocks, indices, ETFs, and cryptocurrencies. The maximum leverage ratios vary depending upon the market and instrument traded and usually, traders can adjust the leverage level directly on the broker’s trading platform.
Understanding leverage in forex enough to know when to use it and when not to is critical to Forex trading success. And don’t get fooled by the favorite selling point of forex brokers – high leverage ratios. Yes, you can make a huge killing using huge leverage in forex trading and it certainly increases the potential profits in the Foreign Exchange market. But, you should also know that you could easily be killed by huge leverage provided by forex brokers as well. In the words of many forex traders and professional traders- leverage is a double-edged sword.
What do I mean by that?
When leverage works in forex trading, it significantly magnifies your profits. Your head gets BIG and you think you’re the greatest forex trader that has ever lived. But there’s a catch. But when you trade forex, leverage can also work against you. If your trade moves in the opposite direction, leverage will amplify your losses so you could be losing money rapidly.
Here’s a chart of how much your account balance changes if prices move depending on your leverage.
My advice? When you make your first steps in the forex market, be realistic in your expectations and don’t start forex trading with real money and the maximum leverage your forex broker provides. Many forex traders set a relatively low optimal leverage ratio so they’ll be able to control their brokerage account and reduce the high risk of trading with high forex leverage ratios.
Play it safe. Protect your capital. And even if you decide to use a low leverage ratio, you need to ensure you use key risk management tools and be alert to a margin call on your trading platform.