In finance, leverage is the practice of using borrowed capital (money) to finance an investment. Leverage can be a helpful tool when investing in currencies, stocks, or other securities. We will now explain how leverage works in forex.
- In forex, leverage is the ratio of the amount used in a transaction to the required deposit
- Leverage is widely used in forex trading
- Forex traders use leverage to increase the size of their positions by borrowing from their broker
- When using leverage, brokers require traders to set aside a portion of the trade value as collateral
- Leverage carries high risk as it amplifies potential losses
What is leverage in forex?
In forex, leverage means borrowing money from your broker in order to open larger positions. This practice is widely used in the world of forex trading, where investors have access to some of the highest levels of leverage among all asset classes. For stocks, the typical leverage level is 2:1, whereas in forex it can be as high as 200:1 to 300:1.
Forex traders use leverage to amplify the profit of their trades. If you open a larger position, your potential profit will also be larger.
Currency pairs typically move in a tight range during a trading day; major pairs seldom move more than 1% a day. In order to capture and capitalize on such small changes in the exchange rate, traders need to open large positions.
But - and this is very important - leverage will also amplify potential losses. If your trade turns loss-making (i.e. the exchange rate moves against your trade), you may end up losing more money than you actually have when you use leverage. In order to mitigate the risk of excessive leverage, the European Securities and Markets Authority (ESMA) introduced leverage limits for retail traders. The authority capped available leverage for major currency pairs at 30:1 and for non-major currency pairs at 20:1.
It is crucial for forex traders to understand how to handle leverage and implement risk management techniques to reduce potential losses.
Forex leverage and margin requirement
When you open a forex trading account at a broker, you will be allowed to trade on margin, in other words to use leverage. Some brokers may limit the amount of leverage new traders can use, others will not.
If you are looking to open a forex trading account, check out our top list of the best forex brokers in the world, compiled by our brokerage analysts after testing their services with real money.
In most cases, you can adjust the size of your trade based on your desired leverage, but the broker will ask for a portion of the trade's value to be set aside in your trading account. This amount of money is called margin.
The margin requirement (i.e. how much money you need to keep in your account for a trade) can differ based on the value of a trade. For example, with a 1 standard lot USDJPY long position ($100,000), the broker may require the investor to maintain $1,000 in their account as margin, meaning that the margin requirement is 1%. However, the requirement may be higher if the value of a trade is smaller. For new accounts, brokers tend to set higher margin requirements.
The margin requirement also depends on the currency pair you trade. For more exotic or volatile currencies, the requirement is typically higher, it can be as much as 10%-15%.
When you open a forex position, the leverage will be set automatically. At some forex brokers, you can manually change this level (i.e. reduce it if you wish to), but not all brokers offer this service.
As a general rule, use stop-loss when you trade on margin (use leverage) in order to avoid losing massive amounts of money or more money than you actually have.
Example of using leverage
Let's say your account balance is $1,000 and you open a long EURUSD position with a volume of 10,000 and with 1:100 leverage. The exchange rate is 1.1 when you open the position. The required margin for this position will be $110 (€10,000 x 1/100 x 1.1 =$110).
If the market goes up by 100 pips, your gain will be $100, since the 1 pip value in the EURUSD currency pair is $1 for a trade size of 10.000 units. If the market goes down by 100 pips, your loss will be $100.
Leverage = 1 / Margin requirement
If the margin requirement is 1%, the leverage will be 1 / 0.01 = 100.
If you are not sure what some of the terms used in this article mean, check out our forex trading glossary.
What leverage should a beginner use?
If you are a beginner, use low leverage until you learn position sizing. For example, 10:1 is considered low leverage in forex trading. If you really want to be on the safe side, consider maximizing your leverage at 1:1. Beginners often commit the common mistake of using too high leverage, which can easily result in massive losses. You can gradually increase the leverage level as you become a more experienced trader.
What is a good leverage?
There is no such thing as good leverage. The appropriate leverage ratio for a trade depends on the trader's risk appetite. As a general rule, beginners should use lower leverage ratios until they learn the ropes of the trade.
Can leverage make you rich?
Leverage in itself will not make you rich. Leverage will only allow you to increase the size of your trades. The key to success in forex trading is proper risk management.
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