What is leverage in Forex trading?

What is leverage in Forex trading?

There are more and more traders who are deciding to move into the FX market. Trading currencies online is accessible for many traders and whilst each person will have their own reasons for trading in this market, the level of financial leverage available remains one of the most popular reasons for traders choosing the FX market. If you are a rookie trader, you may be asking 'what is leverage in Forex trading?' and 'how can it be useful?'. This article will provide you with a detailed overview on leverage in the Forex market, its advantages and disadvantages, along with a list of possible applications and restrictions.

What is leverage in FX?

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 0.01 lots, ECN and 500:1 leverage. While each of these terms may not be clear to a beginner, the request to have Forex leverage explained seems to be the most common one.

Financial leverage is an account boost for Forex traders. With the help of leverage, a trader can open orders that can be as large as 1,000 times more than their own capital. In other words, leverage is a way for a trader to trade much bigger volumes than he would using only his own trading capital.

Many traders would define leverage as a credit line that a broker gives to his client. This isn't exactly true, as leverage does not have the features that are issued together with credit. First of all, when you are trading with leverage you are not actually 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. Besides that, there is also no interest on leverage - 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, leverage in Forex 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 on his trading account. A regular 1 lot on MetaTrader 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 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 the size of the trading position and profits could be higher.

Let's assume a trader with 1,000 USD on their account balance wants to trade big and his broker is supplying a leverage of 500:1. 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. This way a trader can actually request his orders of 500 times the size of his deposit to be filled. This is an important point to take home in understanding leverage in Forex.

This way, if 500:1 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 detailed look at its application and find out what the best possible level of gearing in FX trading is.

What leverage to use in Forex?

It is hard to determine the best level one should use, as it mainly depends on the individual trader's trading 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 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, he is mainly looking to extract the maximum amount of profit within a limited time. What is the best leverage for Forex in this case? Usually such a person would be looking to employ high, or in some cases, the highest possible leverage to assure the largest profit while trading small market fluctuations.

From this we can see that the Forex leverage 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 no or low leverage. A desired leverage for a positional trader usually starts at 5:1 and goes up to about 20:1. When scalping, usually traders tend to employ a leverage that starts at 50:1 and may go as high as 500:1.

Knowing 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 profitable trades. Usually a trader is advised to experiment with leverage for his strategy for a while to find the most suitable one.

FX broker offers

Unlike futures and stock brokers that offer no or tiny leverage, the offers from FX brokers are much more attractive for traders that are looking to enjoy the maximum gearing size. It is hard to indicate the size of the leverage one should look for, yet most of the Forex broker leverages available would start at 100:1 and average at 200:1. There are many brokers that can supply 500:1 leverage. 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.

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How to change Forex leverage?

Once you begin trading with a certain FX broker, you may want to modify the level of leverage available to you. This depends on the broker and we cannot answer this question for every market participant. 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 there. This takes instant effect, so be careful if you have open positions and try to reduce the leverage.

Another important aspect to remember is that leverage is tied to the account deposit level, so sometimes when depositing extra funds to your account, currency trading leverage can be reduced. For example, a broker may supply a leverage 500:1 on the deposits below 1,000 USD and the leverage of 200:1 on the deposits between 1,000 and 5,000 USD. Once a trader has 950 USD and opens a 3 lot position on EUR/USD, he may decide to deposit a bit more to sustain a required margin, yet upon depositing the leverage will be changed and the position would close by reaching the Stop Out level.


Risks

It is important to state that leveraged Forex trading is quite a risky process and your deposit can be lost quickly if trading using a large leverage. Do try to avoid any leveraged or high leveraged trading before you have gained enough experience.

Conclusion

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 useful and harmful to your trading strategy.

Related article:

https://admiralmarkets.com/education/articles/forex-basics/forex-trading-without-leverage