The ability to use leverage is one of the reasons many people are drawn to forex trading. Leverage enables traders to gain greater exposure in financial markets than the amount they have to pay for. It is important for traders of all levels to understand what leverage is and how to use it responsibly. This article provides a detailed explanation of leverage in forex trading, including how it differs from leverage in stock trading and the importance of risk management.
WHAT IS LEVERAGE IN FOREX TRADING?
Leverage in forex trading is a financial tool that allows traders to increase their market exposure beyond their initial investment. For example, with a leverage ratio of 10:1, a trader can enter a position worth $10,000 while only investing $1,000. However, it is important to note that both gains and losses are amplified when using leverage, and in unfavorable market conditions, a trader using leverage may even lose more than their initial deposit.
A leverage ratio of 10:1 means that traders can gain exposure to a trade size ten times greater than the deposit or margin required to fund the trade. This is similar to putting down a 10% deposit on a house; you gain access to the entire property while only funding 10% of its value.
Leverage is typically expressed as a ratio:
| LEVERAGE EXPRESSED IN WORDS | LEVERAGE EXPRESSED AS A RATIO |
|---|---|
| Ten-to-one | 10:1 |
| Thirty-to-one | 30:1 |
| Fifty-to-one | 50:1 |
The amount of leverage available to forex traders is determined by the broker and varies according to the regulatory standards of different regions.
Leverage in Forex vs. Leverage in Stocks
The amount of leverage offered in forex trading differs from that offered in stock trading. This is because major forex pairs are typically more liquid and less volatile than even the most frequently traded stocks. As a result, managing risk and entering and exiting trades is more manageable in the $5.1 trillion per day forex market.
HOW IS FOREX LEVERAGE CALCULATED?
To calculate leverage, traders need to know the trade size (notional value) and the margin percentage. Brokers often provide traders with a margin percentage to determine the minimum equity required to fund the trade. Margin and deposit can be used interchangeably. To find the amount of equity needed to place the trade, simply multiply the margin percentage by the trade size.
Equity = margin percentage x trade size
To calculate leverage, divide the trade size by the required equity.
Leverage = trade size / equity
FOREX LEVERAGE EXAMPLE
Here is an example of how to calculate leverage using the formulas above:
Trade size: 10,000 units of currency (one mini contract on USD/JPY with a trade size of $10,000)
Margin percentage: 10%
Equity = margin percentage x trade size
0.1 x $10,000
= $1,000
Leverage = trade size / equity
$10,000 / $1,000
= 10 times or 10:1
This example illustrates the basics of using leverage when entering a trade. However, it is important to note that traders should not simply calculate the minimum amount needed to enter a trade and then fund their account with that exact amount. Traders must be aware of the possibility of margin calls if the position moves against them, reducing their account equity below an acceptable level determined by the broker.
Trading forex with leverage can result in significant losses. We have calculated a typical scenario of how excessive leverage can impact a trading account and presented the results in a table.
HOW TO MANAGE FOREX LEVERAGE RISK?
Leverage in forex trading can be both beneficial and risky. It's important to use the right amount of leverage and practice good risk management.
Successful traders often use stop-loss orders to limit their potential losses and risk no more than 1% of their account balance on a single trade.
They also aim for a positive risk-to-reward ratio to increase their chances of success over time.
To avoid common mistakes with leverage, check out our Top Trading Lessons guide.
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