What is leverage in forex trading?
Using leverage is popular in forex trading. Traders leverage their buying power by borrowing money from a broker to trade more significant positions in a currency.
So long as you have enough margin in your account, your broker will allow you to access leverage, but there are limits to the amount you can use depending on where you’re based and what currency pairs you want to trade.
Leverage magnifies the returns from favourable movements in a currency’s exchange rate. However, leverage can also magnify losses. Forex traders must learn to manage this force and employ risk management strategies to mitigate potential forex losses.
What does leverage mean in forex trading?
The forex market is the largest global market there is. Close to $5 trillion worth of currency gets exchanged each trading day.
Forex trading involves buying and selling currencies hoping to profit as the sentiment and value of one country’s currency falls or rises versus another.
Investors use leverage to enhance their profits from forex trading, and historically the forex market has provided the highest amount of leverage power available to retail investors.
Leverage is a loan provided to a trader from the broker. Without the facility of leverage, many retail traders wouldn’t have the required capital in their accounts to trade effectively.
A trader’s forex account allows trading on margin or borrowed funds, and brokers limit the amount available.
Brokers require a percentage of the trade’s notional amount to remain in the account as cash, called the initial margin.
What leverage should I use in forex?
The leverage you use on any forex trade will depend on the restrictions your broker allows you to apply and the level of risk versus reward you want to take on.
Brokers will allow you to push the leverage limits if you have enough margin in your trading account to cover the exposure. But brokers in the EU must abide by specific guidelines laid down by ESMA, a subject we’ll cover in more detail further on.
The amount of leverage you use depends on your preferred trading style and how aggressive your trading is. For instance, a scalper might access higher leverage levels but require less margin in their account because their trades are short term, and the overall risk per euro or dollar on each trade is far less than a swing trader.
In contrast, a swing trader will probably take on more risk because their overall position size is greater; while the scalper’s risk per trade might be $50, the swing trader might risk $500.
The leverage you use, or need will also vary depending on the overall technique you employ. Your method and strategy might be relatively high in terms of risk versus reward. Therefore, you’ll need more leverage and keep more margin in your account to execute and stay in your trades.
What is the best leverage in forex?
There is no simple answer to this question because, in many ways, the best leverage to apply to your trades is a subjective and, at times, contentious issue.
As previously mentioned, the leverage you need depends on what style of trader you are and the overall technique you use.
Some traders will recoil from using excessive leverage because their approach is driven by controlling risk whenever possible.
Other traders thrive on the opportunity to use leverage because they have so much confidence in their overall strategy.
Examples of leverage ratios
The initial margin required by brokers will vary, depending on the trade size. If an investor buys $100,000 worth of EUR/USD, they might need to keep $1,000 in the account as margin; the margin requirement would be 1%.
The leverage ratio illustrates how the trade size relates to the margin held by the broker. In the example above, the leverage ratio for the trade is equal to 100:1.
For a $1,000 deposit, an investor can trade $100,000 in the currency pair. A 2% margin requirement must be in your account for 50:1 leverage and 4% for a 25:1 leveraged trade.
Your broker is subject to the financial authorities' rules where it’s based. Still, the broker might alter its leverage and margin requirements further depending on how volatile a currency pair is.
For example, GBP/JPY is more volatile and has less trading volume than GBP/USD, so you’d expect to get less leverage on GBP/JPY.
How do I apply leverage in forex?
You can apply different leverage levels up to your broker’s limits by selecting from a typical drop-down menu on a platform. The broker will have automatically programmed their platform to help you in this process.
If the leverage level isn’t available or you don’t have enough available margin left in your account, then the trade won’t get executed.
Your broker will then instruct you to increase the capital in your account and recommend what the leverage limits are on the transaction you want to make.
Why forex brokers provide leverage
By now, you probably know that forex pairs don’t fluctuate as widely or wildly as other securities such as equity indices, commodities or individual stocks and shares.
Most currency pairs trade in ranges of approximately 1% during a trading day. In contrast, a popular stock such as a Nasdaq FAANG can fluctuate by 5% in a day. Oil and cryptocurrencies might rise or fall by 10% on any trading day.
Because of this difference in trading ranges, brokers can offer greater leverage on FX pairs than on shares, commodities or equity indices. Brokers might offer 20:1 or 30:1 on currency pairs. When it comes to cryptocurrencies, brokers tend to supply no crypto leverage or 2:1 due to the unpredictable swings in price.
What are the benefits of leverage in forex trading?
The main benefit of using forex leverage is controlling and trading more considerable sums of currency. With 100:1, you’d be managing a trade size of 10,000 with only 100 units of your base currency.
If the leverage weren’t available, then you’d only be trading the 100, making it harder to squeeze profits out of the market. Let’s list a few other benefits.
Before the advent of leverage, only the wealthy or institutions could trade markets. The power allows you to maximise the use of your capital. You can treat your capital as an asset to magnify its ability to trade financial markets.
High leverage is like getting a loan from a broker, but there’s no interest to be paid. It’s like getting a business loan from a bank without needing to pass a credit check.
Leveraging helps you make more significant profits in a shorter period, potentially from a low capital base.
If you use leverage skilfully, you only need to increase your capital input to target increased profits. Even with $500 in your account, you have the chance to earn as if you had access to $50,000 using 100:1 leverage.
- Trade with lower volatility
Leverage can help you to squeeze profits out of FX trading when volatility is low. Even minor price differences and small movements can result in gains if you apply leverage power with care and skill.
What are the cons of leverage?
As previously mentioned, leverage can be a two-edged sword; although profits get magnified, so can your potential losses. Here’s a quick list of pitfalls of using leverage.
Losses can end up massive, and profits can shrink with forex leverage. If you trade using higher leverage ratios, you shouldn’t expect the price will always move in your favour. Quite frankly, excessive leverage power, if poorly applied to your trading technique, can be ruinous.
When you apply leverage, you’re taking on board an added liability. You must ensure a level of margin is available in your account for every trade you execute. In short, leverage is not entirely free, and it comes with added risk.
Once you take the leverage on offer from your broker, you must meet the obligation of this liability. Whether the transaction wins or loses, you must pay for the principal amount.
You must satisfy margin conditions before you get provided with leverage. You must fulfil the transaction size set by the broker. The broker may enact a margin call if you don’t ensure enough capital is in your account to keep your trades live and meet the leverage requirements.
Your portfolio and any live forex positions may become liquidated if you don’t have enough margin because you’re trading at the limits of leverage. Even positions in profit will be closed early.
ESMA leverage restrictions
You must know about the leverage restrictions put in place by the European authority ESMA.
The limits set in place by the European Securities and Markets Authority will have a profound effect on the size of transactions you can execute because it relates to the capital and available margin in your account.
There are leverage limits on opening a position by a European retail client if based in and trading through a European broker. They range from 30:1 to 2:1, which vary according to the volatility of the underlying asset.
- 30:1 for major currency pairs
- 20:1 for non-major currency pairs, gold and major indices
- 10:1 for commodities other than gold and non-major equity indices
- 5:1 for individual equities
- 2:1 for cryptocurrencies
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