Leverage is one of the most important and attractive characteristics of Forex and CFD trading nowadays. With leverage, traders make use of borrowed funds to open orders that are much greater than their capital. The advantages are obvious – traders can increase the potential profits from a successful strategy multiple times. However, using leverage is risky, especially for novices since they are trading with money they do not have and can easily end up losing more than they have invested.
Most brokers offer leverage ranging from 1:2 to more than 1:1,000, depending on the requirements and initial investment of their clients. In most cases, traders would be able to choose between 1:50, 1:100, 1:200, etc. leverage rate when trading currency pairs. Different leverage levels would be suitable for traders with different knowledge and experience. When deciding how much to borrow from their broker, traders also need to consider their individual needs and the strategy they plan to apply.
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What Is Financial Leverage?
Financial leverage is not a new development in the economy but has been used by banks and companies for decades. In more general terms, it refers to the use of debt to buy assets and increase a firm’s or an individual’s investment. It is an important concept since it directly affects investors’ return on investment and increases the risk.
The purpose of leverage is to allow investing without the need to use too much equity. The idea is that the after-tax profit from a leveraged transaction would exceed the borrowing costs. One simple example of using leverage would be mortgage – when we are purchasing a real estate, we are financing a portion of the purchase price with mortgage debt. In other words, we use leverage to avoid paying the full price with our equity.
Leverage in Trading
The name of this technique comes from the effect of the lever. In physics, a lever is a simple machine that amplifies an input force to provide a greater output force. In trading and Forex trading, in particular, leverage allows traders to control much larger amounts in a trade than they would be able to with only the capital they own.
Also referred to as margin trading, leveraged trading is offered by brokers for different financial instruments, including options, futures, and Forex trades. Leverage is commonly used when trading contracts for difference (CFDs) but it can also be applied to stocks or indices, for instance. It is important to understand that leverage does not increase the profit potential of a trade – rather, it multiplies the profits or losses from a transaction.
Another essential part of trading with leverage is margin. Although interconnected, leverage and margin are not the same. While leverage refers to the ratio of clients’ capital to the money borrowed from the broker, margin is the required minimum traders need to own. When they use leverage for opening a position, they do not need to deposit the full value of the traded security – they just need to provide a portion of the total amount and this is called the margin. In this sense, margin is required to cover some or all of the credit risk traders pose for the broker.
There is a simple formula that shows the connection between leverage and margin – to calculate the leverage ratio, we just need to divide the value of the total transaction to the margin level we are required to deposit. For instance, if the value of the transaction is $100,000 (which is the value of a standard lot in Forex trading) and the required margin is 1%, then in monetary terms, we will need to have $1,000 as margin to open the position.
To calculate the used leverage for this trade, we divide $100,000 by $1,000. Thus, the leverage ratio is 100:1. It is often displayed in reverse, however – 1:100. This is quite high leverage but it is also very common in currency trading.
How Does Leverage Work in Forex?
Leverage could be as high as 1:1,000 in Forex trading and while this may sound a bit too extreme for novices, there is a good reason why Forex is typically associated with high leverage ratios. In the foreign exchange market, exchange rate movements are measured in pips (“percentage in point”) – a unit of change that is just a fraction of a cent. For instance, if the exchange rate of GBP/USD is initially 1.9500 and it moves 100 pips, it will increase to 1.9600.
As we can see, price movements are very slight, while transactions are carried out in sizable amounts. A Forex trade worth $100,000, which is the standard trading lot, is then very common. However, the vast majority of retail traders would never be able to afford to trade such huge volumes and the foreign exchange market would be accessible only to large banks and institutional traders.
This is where leverage comes in – it allows individual, retail traders to buy and sell sizable amounts of currency pairs with only a fraction of the required value for the transaction. When we trade amounts of $100,000 or even more, the potential profits from even the slightest price changes could be significant. Moreover, retail traders can open leveraged positions with micro and mini lots with even less capital.
The available leverage levels may differ considerably, depending on the broker traders choose to work with, as well as on the type of financial instrument they wish to trade. In addition, financial regulators in certain jurisdictions restrict the maximum leverage that can be offered on derivative products such as CFDs or on Forex pairs. The majority of large, respectable Forex brokers would not provide leverage ratios of more than 1:400 even on the major currency pairs. However, brokers operating without a proper license would sometimes offer prospective clients cash bonuses and leverage of over 1:500.
Is 1:100 Leverage Suitable for You?
Once traders decide they wish to trade on the foreign exchange market, they can choose from hundreds of online Forex brokers. Each firm would offer them different trading conditions and among the most important things to consider is the leverage level for currency pairs. It is difficult to determine the best leverage traders should use since the specific levels depend on a range of factors, including the individual knowledge, trading strategy, and tolerance for risk.
Moreover, the particular leverage ratio should depend on traders’ projection for the upcoming market movements. Traders should decide how long they should keep a position open before they pick a specific level of leverage. Typically, smaller leverage should be used with positions that remain open for long periods of time. When traders plan to keep a position open for only a few minutes or even seconds, they should be looking for the maximum leverage they can get. This is how they can extract the maximum profit with limited equity and within a limited amount of time.
Many Forex brokers would offer their clients leverage up to 1:100. For some traders, this may be too high, whereas, for others, this level is standard for trading major currency pairs. In reality, traders should decide whether 1:100 leverage is suitable for them based on the strategy they have chosen to apply. Such levels are best for scalping, for instance. Scalpers would typically use leverage ranging from 1:50 to 1:500 or even higher in an attempt to extract the maximum potential profit from multiple short-term trades.
Scalping is a method for trading, which is based on real-time technical analysis and involves holding an asset for a few seconds or for up to a few minutes. It is mostly used by Forex brokers since the market is extremely liquid, allowing them to enter and exit trades several times a day. Scalpers look to make small profits from multiple trades during the busiest hours of the day. They typically aim at investing less equity per trade compared to other types of traders but they pair it with higher leverage.
Leverage levels around 1:100 are also suitable for day traders and for those who are experienced enough in the foreign exchange market. It is perfect for those who wish to trade with higher leverage and are able to manage the risks arising from it. It should be noted, however, that the available leverage would often depend on the account deposit level. Brokers would not offer 1:100 leverage to new clients who have opened mini and micro accounts with minimum capital.
Advantages of 1:100 Leverage in Forex
The advantages of using relatively high levels of leverage in Forex trading are obvious. The most important thing is that when using 1:100 leverage, traders will be able to control larger positions and make the most of their capital. As mentioned above, the use of leverage does not make trades more profitable – it only amplifies the effects of a successful trade and traders can earn more with a good strategy.
This means that with a capital of only $100, traders can open positions worth up to $10,000, which is referred to as 1 mini lot. Of course, traders can trade 10 mini lots with a total value of $100,000 and they will need to invest only $1,000. If their trades are successful, they could make a profit of up to a few thousand dollars.
There are several other great advantages of using leverage for Forex trading some novices struggle to comprehend. Most importantly, when using 1:100 leverage, for instance, traders use borrowed capital that is 100 times their own investment. However, this “debt” is only virtual, which means that they do not actually receive this money. Therefore, they do not need to repay anything to the broker.
The leverage they get – the virtual borrowed capital, acts as a boost to their account and is active only as long as the position is kept open. Once traders close their leveraged position, their profits would be based on the combined amount of the borrowed funds and their own funds.
Another great thing about Forex leverage is that it comes with no interest. Unlike the leverage example, we described above for purchasing property, trading leverage does not cost additionally for borrowing money. The mortgage we take when buying a home comes with an interest rate paid monthly to the bank. Forex brokers, on the other hand, offer leverage for free and instead earn their profits from the spread and various commission fees.
Risks of Using 1:100 Leverage
As we have explained above, leverage of 1:100 (it could be displayed as 100:1) is considered quite common for currency trading. However, it should be used only by experienced traders who have developed effective and successful strategies while maintaining a low risk through stop losses and other money management tools. The risks of using excessive leverage are just as obvious as the advantages – leverage multiplies the losses if the trade is not successful.
For example, if you invest $1,000 and use a leverage of 1:100, you will be able to spend $100,000 on an open position. This is a very attractive offer, especially if you are confident that your strategy will work. However, if you fail to predict even the slightest price movements, then it is very likely that you will lose your entire investment in a matter of hours.
In fact, it is possible to lose thousands of dollars if the market moves against you and you are trading large volumes with high leverage – higher than you could normally afford. It is a good tactic to never risk more than 2% of your entire balance on a single trade – if the potential loss from the transaction is 2% of your capital, you simply need to reconsider your trading style and decision-making. This is particularly important for those who are still new to Forex trading with leverage – they should stick to even lower percentages for the potential losses and lower levels of leverage.