How does leverage work in forex trading?

What is leverage in forex trading and how does it work?

Leverage in forex trading is a mechanism that enables you to hold a larger position in the foreign exchange (FX) market with a comparatively smaller amount of capital. Typically expressed as a ratio, leverage works by using funds borrowed from your trading provider to increase your position size. With a leverage ratio of 20:1, for example, you could open a position worth $20,000 with just $1,000 of your own funds.

The amount of leverage available often depends on how volatile or liquid a market is. Less stable and less traded markets typically offer lower leverage. This helps protect your positions from sudden price changes. On the other hand, markets with high liquidity and lower volatility can offer much higher leverage ratios.

Forex trading is known for having some of the highest leverage ratios in finance. The difference in leverage between forex and stocks, for example, is quite significant. In the stock market, leverage usually starts at 5:1. In contrast, leverage in the forex market can go up to 30:1 for the most commonly traded currency pairs.

Leverage will either amplify your returns or increase your losses, depending on the outcome of a trade. That’s why it’s important that you understand how leverage works and manage your risk diligently.

Leverage and margin explained

Leverage and margin are closely related concepts in trading. The terms are sometimes used interchangeably, but it's important to remember that they’re not one and the same. Leverage is the mechanism that magnifies your profits and losses, while margin is the specific amount of money you must have to open a position with amplified exposure.

• Leverage enables you to control a larger position size with a proportionally smaller amount of capital. As mentioned, it's usually expressed as a ratio, eg 20:1, which means you’d control $20 in the market for every $1 of your position size
• Margin is the deposit you put down to open a leveraged position. It represents a fraction of your total trade size. So, you could lose more than your outlay if the market moves against you. Margin requirements are usually higher for currency pairs that are more volatile, ie where there’s an increased risk of large price fluctuations

How to calculate leverage in trading

The formula to calculate leverage in trading is: total value of trade / margin required.

For example, if you're trading $40,000 worth of EUR/USD and the margin required is $2,000, leverage for this trade is 20 ($40,000/$2,000). So, the leverage ratio for this trade is 20:1.

Example of leverage in forex trading

Let’s say you choose to trade GBP/USD using a leverage ratio of 20:1. You’d be able to hold a position worth $20,000 by committing only $1,000. If the underlying price of the GBP/USD currency pair moves by 1% in either direction, the value of your position will change by $200 ($20,000 x 0.01). So, you’d gain or lose $200 on your initial margin of $1,000. This demonstrates the power and risk involved in trading with leverage.

Benefits and risks of leverage in forex trading

Remember, while leverage can be a powerful tool in forex trading, it requires careful risk management and a thorough understanding of currency market dynamics.

Benefits and risks of forex trading

Forex trading has its own unique benefits and risks, outside of the pros and cons of using leverage to take positions on currency pairs. These include:

• 24/5 trading: the forex market is open 24 hours a day during weekdays. With us, you can trade over 80 major, minor and exotic FX pairs from 1am on Monday until 2am on Saturday (Dubai time). Our GBP/USD, EUR/USD and USD/JPY weekend markets are available from noon on Saturday to 12.40am on Monday (Dubai time) through out-of-hours trading*
• Global market access: forex trading opens doors to international financial markets, enabling you to engage with currencies from major economies and emerging markets. With over 80 currency pairs available when trading with us, you can take a position on economic shifts, geopolitical events and more
• High liquidity: forex is the most liquid market in the world because there’s a large number of buyers and sellers looking to make a trade at any given time. High liquidity makes it easy for you to enter and exit positions
• Slippage: given how volatile the market can be, it could happen that the price at which your order is executed is different from the price you requested. To help mitigate the effects of slippage on your forex trades, you can use certain risk management tools
• Volatility: some forex pairs are more volatile than others. Those with lower liquidity – including many minor pairs like USD/SEK – are often more volatile

Leverage in forex trading summed up

• Leverage in forex trading enables you to control larger currency pair positions with proportionally smaller amounts of capital. For example, with 20:1 leverage, you could open a position worth $20,000 using $1,000
• While leverage can amplify profits, it can also magnify losses. Understanding how leverage works and implementing applicable risk management strategies is crucial before engaging in forex trading
• Leverage and margin are related but distinct concepts: leverage is the mechanism that magnifies profits and losses, while margin is the collateral required to open a leveraged position
• The formula to calculate leverage is: total trade value divided by margin required. For instance, a $40,000 trade with $2,000 margin has leverage of 20:1