What is leverage in forex?

Many people are attracted to forex trading due to the amount of leverage that brokers provide. Leverage enables you to gain more exposure in financial markets than what you’re required to pay for trading them.

It’s important to understand what leverage is and how to use it responsibly. This lesson will explore forex leverage in depth – including how it differs to leverage in stocks – and the importance of risk management.

What is leverage in forex trading?

Leverage enables you to increase your market exposure beyond your initial investment (known as margin). You can think of the margin as a deposit your broker requires from you to trade a certain product. Your broker then covers the remaining balance to give you full exposure to the market you’re trading.

For example, if you wanted to open a position worth $10,000 of currency, and the broker has a 10% margin requirement, you’d only need to put up $1000 to gain full exposure to the trade size.

However, it’s essential to know that both gains and losses are magnified when you trade with leverage. In the worst-case scenario, you could even lose more money than the initial $1000 you put up to open the trade.

Leverage is usually expressed as a ratio, for example:

Leverage of ten-to-one means that traders can gain exposure to a notional value or trade size ten times more than the deposit or margin required to fund the trade. You can think of this like putting down a 10% deposit on a house; you gain access to the entire house after funding only 10% of its full value.

Brokers usually determine the amount of leverage they offer their clients on any market. However, it must be within the confines of regulatory standards in their region.

Forex leverage differs to the amount of leverage that is offered when trading shares. This is due to the fact that major FX pairs are liquid and typically exhibit less volatility than even the most frequently traded shares.

As a result, it may be more manageable to hedge your risk and keep your trades open for shorter periods in the forex market.

To calculate leverage, you’ll need to know:

• The notional value of the trade (trade size)
• The margin required (usually expressed as a percentage)

Before you enter into a trade, you’ll normally see a margin requirement that’ll help you calculate the minimum amount you need to fund your position. Once you have that, simply multiply it with the trade size to find the amount of equity needed to place the trade, ie:

Margin percentage x trade size = equity needed

And to calculate leverage, you’ll need to divide the trade size by the required equity, ie:

Trade size / equity = leverage

Here’s a quick exercise to check your understanding:

Further, the leverage on this trade would be: $10,000 / $1000 = 10 (or 10:1)

This exercise highlights the basics of how forex leverage is used when entering a trade. However, you’ll need more than just the initial margin to maintain your position in the market.

This is because the market can move against your trade, bringing your account equity below an acceptable level (determined by your broker). When this happens, you’ll receive a margin call or be closed out of your position due to insufficient funds.

The top causes for margin calls, presented in no specific order, are:

• Holding on to a losing trade too long, which depletes usable margin
• Using too much leverage in your account across multiple trades
• Underfunding your account, which will force you to trade with too little margin
• Trading without stops – the market could adversely move against you, eating into your available funds

Trading forex with leverage has the potential to produce large losses. It’s important to consider the margin requirements of each trade before taking your position in a market.

The relationship between margin and leverage

Leverage and margin are closely related. The more margin that’s required on a trade, the less leverage you’ll be able to use. This is because you’ll have to fund a higher percentage of the full value of the trade with your own money and ‘borrow’ less from your broker.

Leverage has the potential to produce large profits and large losses, which is why it’s crucial that you use it responsibly. Take note that leverage can vary between brokers and will differ across different jurisdictions – in line with regulatory requirements. Below are typical margin requirements and the corresponding leverage:

How to manage forex leverage risk

Leverage can be described as a two-edged sword, providing both positive and negative outcomes for forex traders. This is why it’s essential to incorporate sound risk management.

You can mitigate your downside risk when trading with leverage by using stops. We’ll discuss this later on in this course.

Further, it may be useful to risk no more than 1% of your account equity on any single trade and no more than 5% of your account equity for all open trades at any point in time.

You could also use a positive risk-to-reward ratio on all your trades in an attempt to achieve higher probability trades over time.