Leverage can provide substantial opportunity for forex traders, but it can also present them with a significant amount of risk. While an investor may be able to use borrowed funds to amplify returns greatly, harnessing leverage can also dramatically magnify losses.
To harness leverage effectively, traders must not only learn its basics, but also develop a keen sense of its costs and benefits. As always, traders need to keep their emotions under control. Investors might feel quite enticed by the high returns they can generate by using leverage, but they should also keep in mind that using this approach can also create major losses.
Leverage In Forex Trading
There are many different places where investors can potentially take advantage of leverage to amplify returns, including stocks and real estate, but currency trading stands out because of the amount of leverage traders can use.
The forex market permits so much use of debt because it is the largest and most liquid market in the world. As a result, investors looking to trade currencies have the freedom to enter and exit positions rather easily. Due to this flexibility, traders have at least some ability to control their exposure to losses and gains. Pursuant to this control, brokers are willing to grant forex traders significant amounts of leverage.
Types Of Leverage Ratios
Ratio analysis has many facets, each with a specific function. For instance, equities traders typically reference the traditional price-to-earnings ratio (P/E) in an attempt to ascertain a share's intrinsic value. Conversely, derivatives traders view leverage ratios as being vital to quantifying the margin to position size relationship.
Margin is a good-faith deposit made by the trader to a broker. It is used to facilitate the trade of a security and is a key aspect of applying leverage in the live market. Accordingly, margin requirements are established by brokerages and formalised exchanges to protect market participants from excessive risk and undue capital loss.
In forex, leverage ratios are used to compare the degree of utilised margin to a position's notional value. To do so, forex traders rely on two types of leverage ratios:
Margin-Based Leverage Ratio
The margin-based leverage ratio expresses how large of a position one may open with reference to the forex trading account's size. As an example, a margin-based ratio of 50:1 indicates that a trader may open new positions in the market 50 times that of the account balance. If Trader A has a £1,000 account, then 50:1 leverage enables a forex position size with an aggregate value of £50,000.
Margin-Required Leverage Ratio
The margin-required ratio is derived from the amount of margin needed to open a specific position. Essentially, it is the percentage of a position's aggregate value that must be posted to satisfy margin requirements. To illustrate, assume that Trader A is engaging the forex with 50:1 leverage and a £1,000 account. Given the £1,000 balance and £50,000 position size, the margin-required ratio is 2.0% (1,000/50,000 = 0.02).
|Margin-Based Leverage Expressed as Ratio||Margin Required of Total Transaction Value|
Volume Of Leverage
By borrowing money from a broker, you could potentially make a trade that is 10 times, 20 times or even 50 times the amount of equity you want to put toward a trade. Doing some basic math, this means that if you have £10,000 worth of equity, you could buy contracts worth £100,000, £200,000 or even £500,000. While this situation provides substantial opportunity, it also comes with significant risk.
If your broker is offering a £100,000 contract and 10 times leverage, you can buy it using £10,000 worth of equity. Should the contract rise in value to £110,000, you will reap a £10,000 profit. While this amount represents a 10% return on the contract price, it provides a 100% return on equity.
However, if the value of the same £100,000 contract declines to £90,000, you will incur a £10,000 loss, which represents 10% of the contract's value and 100% of the equity you invested. With numbers like this, it is easy to see how the losses stemming from these bets could add up quickly.
If the equity in your account falls below a certain amount, the broker will issue a margin call. Once this demand is made, you can either add more cash to your account or liquidate existing positions to bring the equity to a certain level. Should you fail to meet the margin call, your broker can start closing out open positions without first obtaining your approval. In addition, you could end up paying a commission for each transaction made by the broker.
Having these positions closed out without your permission could easily throw a wrench into your trading plans. It could reduce your profits and also interfere with any trades you set up specifically to manage risk.
Advantages And Disadvantages Of Leverage
Perhaps the biggest calling card of forex trading is the availability of leverage. Depending upon the instrument and market conditions, leverage upwards of 500:1 may be available to participants. Of course, when applying high degrees of leverage, there are several distinct pros and cons best recognized before jumping in with both feet.
- Enhances Capital Efficiency: In forex, capital efficiency is the comparison of how much money is being risked relative to potential profits. High degrees of leverage help traders maximise the potential of their risk capital and turn minimal investments into substantially larger returns.
- Extraordinary Profits: The greater the applied leverage, the greater the potential profits. Through opening inherently large positions in the market, beneficial moves in pricing can produce extraordinarily positive returns.
- Risk: Make no mistake—applying leverage exponentially increases the trader's risk exposure. As position sizes grow larger, per PIP values also grow. In the case of sudden volatility, capital drawdowns on heavily leveraged positions may be severe. If margin requirements aren't able to be met due to unrealised losses, margin calls and premature position liquidations are possible.
- Stress: The physical and mental stress associated with trading highly leveraged forex positions can be intense. As leverage is increased, the "stakes" of each trade go up dramatically. Subsequently, trader psychology often changes, with big profits leading to a state of euphoria while sizable losses prompt desperation. When in a euphoric or desparate state, traders are more inclined to make emotional decisions rather than strategic ones.
Risk Of Leverage While Trading Forex
Hopefully, it is now quite clear that using leverage in forex trading can be a double-edged sword. However, there are steps you can take to limit your loss of risk.
Practice Makes Perfect
One way you can help mitigate the risk of trading with leverage is working with a practice account before trading with actual funds. You might consider doing this over a trial period, for example three or six months. Using a trading account can be a great way to test whatever trading system you have developed.
Limit Your Losses
If you make capping your losses a priority, you can increase the odds of having a successful trading career. Realistically, not every trade will produce a gain. By learning how to keep your losses within a certain range, you can manage the risk that your capital will quickly dwindle.
Wade In Slowly
If you want to use leverage successfully, you can start out by harnessing a little at a time. While your broker may offer you 100 times leverage, beginning with something as simple as two times might make more sense. With leverage levels like that, any losses you incur would be more modest.
Be Ready To Cut Your Losses
Should one of your positions fall in value, be ready to cut your losses. While many have doubled down on positions after they lost value, this strategy is very risky. Some of the largest losses in history have happened because rogue traders kept adding to losing positions instead of closing them out.
Harness Strategic Stops
Using strategic stops can make it far easier to trade currencies, especially seeing as how the forex markets are open 24 hours a day. In these conditions, your holdings could experience sharp changes in value overnight. You can use strategic stops not only to limit losses, but also to protect any profits you have generated.
Keep A Level Head
One more important consideration is keeping a level head while trading. As you get your feet wet, it is entirely possible you will encounter strings of winning trades as well as series of losing trades. If you have several losing trades in a row, don't despair. Likewise, enjoying a group of winning trades should not make you overconfident.
When leverage becomes involved, the emotional ups and downs that correspond with gains and losses can be even more intense. As a result, it is important to remember that not every trade will be a winner. Because of this, it may be prudent to set up trading systems conservatively.
This article was last updated on 27th July 2021.
Senior Market Specialist
Russell Shor (MSTA, CFTe, MFTA) is a Senior Market Specialist at FXCM. He joined the firm in October 2017 and has an Honours Degree in Economics from the University of South Africa and holds the coveted Certified Financial Technician and Master of Financial Technical Analysis qualifications from the International Federation…