All about leverage in Forex trading
Forex trading is becoming more and more attractive to the traders worldwide due to a number of factors, which are too many to list here. Probably, the number one reason why people are getting into currency trading is leverage. This term, which might seem quite mysterious to newcomers and basic to seasoned traders, is the first thing to know when you are starting FX trading. So, enough with the intrigue. Let's answer a couple of initial questions: "what is leverage in Forex trading?" and "what is the purpose of leverage?" You will find all the necessary information in the current article, including cons and pros of leverage and some guidelines on its use.
Explaining leverage in FX
Before choosing a broker to trade with, it is recommended to, at least, understand what it means when an ad says "ECN offering 400:1 leverage" or something like that. With Forex leverage explained, it all starts to make perfect sense. What's more, this leverage can serve as an important factor for choosing a trading platform/broker.
So, what is leverage in FX? While generally, leverage is the amount of money which is borrowed to one to make an investment, in currency trading, it's what a trader borrows to open a position. Leverage allows opening orders which exceed the trader's capital 20, 100, 500, or even 1,000 times.
At the same time, leverage is rather an account boost than a credit issued by a broker. While both mean some financial resources borrowed from another party, leverage does not have the main characteristics of a credit. For example, payback is not expected from a trader. You just do not exceed your margin limit and close your position before the margin call (otherwise, you may experience high losses). Another good thing is that traders do not pay any interest. They get their leverage for free with no obligation to pay it back. Instead, there are FX swaps rates that are charged from traders for rolling over their positions overnight. And still, swap rates can also be paid to the trader.
So, Forex trading leverage is a loan which allows a trader deal with much larger volumes and open bigger positions. Unlike credits, leverage has no interest rate and doesn't presume paying it back. Below is some more detailed information on how the leverage works in currency trading.
Now the most important: How does Forex leverage work?
Every trading platform has a standard size of a lot, which is usually 100,000 units in any given currency. Not every trader, especially a beginner, will have that amount to invest. With some brokers, such as Admiral Markets, it is also possible to trade fractions of lots (mini and micro lots), say, 1/100 of a lot. For a trade of such an amount will not bring much revenue, it is natural for traders to seek opportunities to increase their trading position size to make a bigger profit. Leverage offered by a broker is an instrument that allows one trade entire lots while having limited capital on their trading account. Thus, it is a mechanism through which you can trade 100,000 USD with only 1,000 USD on your account.
Let's move along in understanding leverage in Forex. For instance, a trader with a capital of 1,000 USD wants to trade more than one lot, let's say, 4. It can be easily done with a 400:1 leverage ratio offered by the broker. So, the maximum position opened by a trader will equal 400,000 USD (if that is the currency of the trader's choice).
The formula to calculate the maximum size of a position is simple. You take the leverage (400:1) and multiply your balance on the number before a colon: 1,000 USD x 400 = 400,000 USD. To estimate your potential profits which is possible thanks to leverage, you simply multiply the leverage by your potential profit from your current balance: while you could earn 15 USD with no leverage, you will be getting 6,000 USD with 400:1 leverage. Of course, your losses do get multiplied as well, which is why traders need to be very cautious when they utilize leverage.
Having provided an explanation of gearing (a synonym for leverage) in currency trading and having supported it with a few examples, it is time to look at the available leverage ratios and choose the most suitable for your trading needs.
How to choose what leverage to use in Forex
So, which leverage ratio is better for trading and profiting, the high one or the small one? This is a tough question, as your choice should depend on both your trading strategy and the situation within the market. Generally, those who keep their positions open for longer periods of time should avoid trading with higher leverages. It must be tempting to utilize higher leverage while expecting big price fluctuations and, therefore, keep your positions open; however, it is very unreasonable in terms of risks. On the other hand, small periods of time can bring only small market moves; this is why using higher leverage is less risky. What's more, it might bring you large profit within the shortest time possible. Now, what is the best leverage for Forex traders? Let us talk numbers, ratios and all.
What we understood from the previous information, a decision on the right Forex leverage ratio should be consistent with the choice of your strategy. If you are a breakout trader, then you probably want to go after a greater piece of profit in no time at all. While the volatility is small, the only chance to increase the earnings is by raising leverage ratio. This is why such traders can strive for 50:1 or even 500:1 leverage ratio. For positional traders, taking high leverage is both undesired and not recommended. This is why they usually trade with 5:1 up to 20:1, or even 1:1 (no leverage at all).
When it comes to leverage, Forex traders often forget about patience and rush towards the opportunities as soon as they start to see the potential of a really profitable trade. However, there are too few people who will spend their time testing different leverage ratios with their personal strategies.
On the possible risks
Fortunately, risks in Forex markets are not as high as in stock or commodities markets due to the relatively insignificant market volatility. This is exactly the reason why FX brokers offer much higher leverage. However, it is recommended to avoid high-leveraged Forex trading, especially for the beginners, in order to avoid quick and significant losses.
Leverage ratios offered by Forex brokers
Many find Forex brokers much more attractive in terms of offered leverage ratios. They win over, let's say, stock brokers. Forex broker leverage can vary between 100:1 and 200:1. It can also reach 500:1 with a significant number of currency brokers, but it can go up to 1,000:1 extremely seldom. Of course, it is good when Forex brokers are getting so flexible in gearing; it is well understood that bigger rates could attract more traders, both professional breakouters and hot-headed newcomers. On the other hand, how many traders would really want to utilize such cosmic rates in practice?
Changing leverage in Forex
Leverage ratio is not fixed: brokers usually state the highest ratios possible. Traders can normally change their leverage level at any time; however, the procedure might vary with different brokers. So, if you selected 200:1 and want to change the ratio to 20:1, then the most common thing to do is go to the Settings on your Account page. Bear in mind that the changes will come in effect instantaneously and will also be applied to all positions that might be currently open.
There is one essential limitation: your currency trading leverage might decrease when you make an additional account deposit, as it is always adjusted to your account balance. Let's say you have 900 USD on your account, and your broker offers 500:1 leverage ratio for deposits up to 1,000 USD and 200:1 ratio for deposits of 1,000 through 5,000 USD. So, whenever you want to open a position of 3 lots and add up 100 USD to keep up with a margin, this will result in closing of your position, as the leverage level will be modified automatically.
This article has provided the essential information on leverage in currency trading. Now you understand how it makes FX more attractive to traders. You have also an idea about how to calculate Forex leverage and how to adjust it to your strategy in trading. We also hope that you are now fully aware of the risks associated with high gearing: you can profit more, but you can lose a lot too. So, always stay cautious and use leverage to your advantage.