What is Leverage in Forex Trading?
If you are a rookie trader, you may find yourself asking questions such as 'what is leverage in Forex trading?' and 'how can it be useful?' This article will provide you with answers to these types of questions, together with, a detailed overview of Forex leveraging, its advantages and disadvantages, and a list of possible applications and restrictions.
In general, leverage enables you to influence your environment in a way that multiplies the outcome of your efforts without increasing your resources.
In the world of trading, it means you can access a larger portion of the market with a smaller deposit than you would be able to via traditional investing. This gives you the advantage of getting greater returns for a small up-front investment, though it is important to note that traders can be at risk of higher losses. In finance, it is when you borrow money, to invest and make more money due to your increased buying power. Once you return what you borrowed, you are still left with more money than if you had just invested your own capital. Let's look at it in more detail for the finance, Forex, and trading world.
What is Financial Leverage?
Leverage in finance pertains to the use of debt to buy assets. This is done in order to avoid using too much equity. The ratio of this debt to equity is the formula for leverage (debt/equity ratio) whereby the greater the proportion of debt, the higher the amount of margin. If a company, investment or property is termed as 'highly geared' it means that it has a greater proportion of debt than equity. When this type of debt is used in such a way that the return generated is greater than the interest associated with it, an investor is in a favourable position. However, an excessive amount of margin is risky, given that it is always possible to fail to repay it.
(Note that the levels shown in Trades 2 and 3 is available for Professional clients only. A Professional client is a client who possesses the experience, knowledge and expertise to make their own investment decisions and can properly assess the risks that these incur. In order to be considered a Professional client, the client must comply with MiFID ll 2014/65/EU Annex ll requirements.)
Financial and operating margin is quite different from each other, with the latter consisting of a business entity and is calculated as a sum total of the amount of fixed costs it bears, whereby the higher the amount of fixed costs, the higher the operating leverage will be. So, what does leveraging mean for a business? It is the use of external funds for expansion, startup or asset acquisition. Businesses can also use leveraged equity to raise funds from existing investors.
Why Use Financial Leverage?
Margin trading is very popular among traders and is most commonly used for these three basic purposes:
- To expand a firm's or an individual's asset base and generate returns on risk capital. This means that there is an increase in ROE and Earnings Per Share.
- To increase the potential of earnings.
- For favourable tax treatment, since in many countries, the interest expense is tax deductible. So, the net cost to the borrower is reduced.
When the cost of capital debt is low, leveraged equity can increase returns for shareholders. When you own stock or shares in a company that has a significant amount of debt, you have leveraged equity. Therefore, the stockholder experiences the same benefits and costs as using debt.
Day trading leverage allows you to control much larger amounts in a trade, with a minimal deposit in your account. Leveraged trading is also known as margin trading. You can open up a small account with a brokerage, and then essentially borrow money from the broker to open a large position. This allows traders to magnify the amount of profits earned.
Remember, however, that this also magnifies the potential losses. Stock market margin includes trading stocks with only a small amount of trading capital. This is also seen in Forex leveraging, wherein traders are allowed to open positions on currency pairs larger than what they can afford with their account balance alone.
It should be remembered that margin does not alter the profit potential of a trade; but instead, reduces the amount of equity that you use. Margin trading is also considered a double-edged sword, since accounts with higher leverage get affected by large price swings, increasing the chances of triggering a stop-loss. Therefore, it is essential to exercise risk management.
What is Leverage in Forex?
Financial leverage is essentially an account boost for Forex traders. With the help of this construction, a trader can open orders as large as 1,000 times greater than their own capital. In other words, it is a way for traders to gain access to much larger volumes than they would initially be able to trade with. More and more traders are deciding to move into the FX (Forex, also known as the Foreign Exchange Market) market every day.
Trading currencies online is an exciting experience, and is accessible for many traders, and while each person will have their own reasons for trading in this market, the level of financial margin available remains one of the most popular reasons for traders choosing to trade on the FX market.
When visiting sites that are dedicated to trading, it's possible that you're going to see a lot of flashy banners offering something like ''trade with 0.01 lots, ECN and 500:1 leverage''. While each of these terms may not be immediately clear to a beginner, the request to have Forex leverage explained seems to be the most common one.
Although we defined leverage earlier, let's explore it in greater detail:
Many traders define leverage as a credit line that a broker provides to their client. This isn't exactly true, as margin does not have the features that are issued together with credit. First of all, when you are trading with leverage you are not expected to pay any credit back. You are simply obliged to close your position, or keep it open before it is closed by the margin call. In other words, there is no particular deadline for settling your leverage boost provided by the broker.
In addition, there is also no interest on margin, instead, FX Swaps are usually what it takes to transfer your position overnight. However, unlike regular loans, the swap payments can also be profitable for a trader. To sum up, margin trading is a tool that increases the size of the maximum position that can be opened by a trader. Now we have a better understanding of Forex trading leverage, let's see how it works with an example.
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How Does Forex Leverage Work?
Let's say a trader has 1,000 USD in their trading account. A regular lot of '1' onMetaTrader 4 is equal to 100,000 currency units. As it is possible to trade mini and even micro lots with Admiral Markets, a deposit this size would allow a trader to open micro lots (0.01 of a single lot or 1,000 currency units) with no leverage put in place. However, as a trader would usually be looking for around 2% return per trade, it could only be equal to 20 USD.
This is why many traders decide to employ gearing, also known as financial leverage, in their trading - so that the size of the trading position and profits could be higher. Let's assume a trader with 1,000 USD in their account balance wants to trade big and their broker is supplying a leverage of 1:500. This way a trader can open a position that is as large as 5 lots, when it is denominated in USD. In other words, 1,000 USD * 500 (the leverage), would equal a maximum size of 500,000 USD for the position. The trader can actually request orders of 500 times the size of their deposit.
This way, if 1:500 leverage is used, a trader would be making 500 USD instead of 1 USD. It is of course important to state that a trader can lose the funds as quickly as it is possible to gain them. Now, as we have understood the definition and a practical example of leverage, let's take a more detailed look at its application, and find out what the best possible level of gearing in FX trading is. Admiral Markets offers varying leverages which are dependent on client status via Admiral Markets Pro terms.
For retail clients, leverages of up to 1:30 for currency pairs and1:20 for indices are available. For professional clients, a maximum leverage of up to 1:500 is available for currency pairs, indices, energies and precious metals. Users can also participate in futures trading leverage on currency, stock and commodity CFDs. Both retail and professional status come with their own unique benefits and trade-offs, so it's a good idea to investigate them fully before trading. Find out today if you're eligible forprofessional terms, so you can maximise your trading potential, and keep your leverage where you want it to be!
Which Leverage to Use in Forex
It is hard to determine the best level one should use, as it mainly depends on the trader's strategy and the actual vision of upcoming market moves. As a rule of thumb, the longer you expect to keep your position open, the smaller the leverage should be. This would be logical, as long positions are usually opened when large market moves are expected. However, when you are looking for a long lasting position, you will want to avoid being 'Stopped Out' due to market fluctuations.
In contrast, when a trader opens a position that is expected to last for a few minutes or even seconds, they are mainly aiming to extract the maximum amount of profit within a limited time. What is the best Forex leveraging in this case? Usually, such a person would be aiming to employ high, or in some cases, the highest possible margin to assure the largest profit is realised, while trading small market fluctuations.
From this we can see that the margin ratio strongly depends on the strategy that is going to be used. To give you a better overview, scalpers and breakout traders try to use as high a leverage as possible, as they usually look for quick trades. Positional traders often trade with low leverage or none at all. A desired leverage for a positional trader usually starts at 5:1 and goes up to about 20:1.
When scalping, traders tend to employ a leverage that starts at 50:1 and may go as high as 500:1. Knowing the effect of leveraging and the optimal leverage Forex trading ratio is vital for a successful trading strategy, as you never want to overtrade, but you always want to be able to squeeze the maximum out of potentially profitable trades. Usually a trader is advised to experiment with leverage within their strategy for a while, in order to find the most suitable one.
To learn more about why lower leverage is good for retail traders and what is the success rate for high vs. low leverage, watch this free webinar here:
Trading Crypto on Margin
Leverage trading crypto has also become very popular in recent years and many traders use similar strategies trading Forex as they do on trading digital currencies. Many brokers now offer margin trading on cryptocurrency CFDs. This means traders can speculate on the price direction of a cryptocurrency without owning the underlying asset, storing it and using unregulated crypto exchanges.
Bitcoin leverage trading is also possible. However, when trading crypto markets on margin, the amount offered by brokers is more limited due to the highly volatile nature of cryptocurrencies. With Admiral Markets, retail clients can trade cryptocurrency CFDs like bitcoin with leverage of 1:2.
FX Broker Offers
Unlike futures and stock brokers that offer limited margin or none at all, the offers from FX brokers are much more attractive for traders that are aiming to enjoy the maximum gearing size. It is hard to indicate the size of the margin that a Forex trader should look for, yet most of the Forex brokers in the marketplace offer margin based trading that is available from 2:1 on cryptocurrency CFDs, all the way up to 1000:1. However, this also depends on whether or not the broker is a regulated entity or not.
Brokers that are regulated by well-known regulators such as the UK Financial Conduct Authority, the Cyprus Securities and Exchange Commission and the Australian Securities and Investments Commission, offer limited margin to clients categorised as retail. This tends to be an average of 30:1 for clients categorised as 'retail'. There are also many brokers that can supply 1:500 margin.
Also, in very rare cases it is possible to open an account with a broker that supplies 1,000:1, however, there aren't many traders who would actually want to use gearing at this level.
How to Change Forex Leverage
Once you begin trading with a certain FX broker, you may want to modify the margin available to you. This depends on the broker. With Admiral Markets you can use an industry standardised procedure that includes authenticating to the Trader's Room, selecting your account, and changing the leverage available. This action takes immediate effect, so be careful if you have open positions when you attempt to reduce your margin level.
Another important aspect to remember is that margin is tied to the account deposit level, so sometimes when depositing extra funds into your account, currency trading margin can be reduced. For example, a broker may offer margin trading of 1:500 on the deposits below 1,000 USD, and margin of 1:200 on the deposits between 1,000 and 5,000 USD.
Once a trader has 950 USD, and opens a 3 lot position on EURUSD, they may decide to deposit a bit more to sustain a required margin, yet when the deposit occurs, the leverage will be changed, and the position might close when the Stop Out level has been reached.
We hope that this article has been useful to you, and that by now you have clearly understood the nature of gearing, how to calculate Forex leverage, and how it can be equally be useful or harmful to your trading strategy. It is important to state that margined Forex trading is quite a risky process, and your deposit can be lost quickly if you are trading using large margin. Do try to avoid any highly leveraged trading when you first start out and before you have gained enough experience.
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This material does not contain and should not be construed as containing investment advice, investment recommendations, an offer of or solicitation for any transactions in financial instruments. Please note that such trading analysis is not a reliable indicator for any current or future performance, as circumstances may change over time. Before making any investment decisions, you should seek advice from independent financial advisors to ensure you understand the risks.