Leverage on Forex: Stick to two ends

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Leverage on Forex: Stick to two ends

 

One of the reasons for the popularity of Forex among traders compared to other financial instruments is the possibility of using large leverage. Despite the widespread use of the term “leverage”, few people understand its true meaning and impact on trade.

What is leverage?

Leverage allows traders to use borrowed funds to purchase an investment instrument. When trading on the Forex market, borrowed funds are provided by a broker. Availability of large leverage on Forex allows traders to manage significant amounts of money in the market, having only a small amount of their own funds used to cover margin requirements. To calculate the amount of leverage it is necessary to divide the total amount of the transaction by the required amount of margin.

Total transaction amount
Leverage =
Margin requirement

For example, if you want to deposit 1% of the total amount of the transaction, and you intend to operate one standard lot of USD/CHF, equal to $ 100000, the required amount of margin (deposit) will be $ 1000. In this case, the leverage is 1:100. Similarly, if the margin requirement is 0.25%, leverage will be 1:400.

Credit shoulder Required sum marginsinterest rates)
1:4000.25%
1:2000.50%
1:1001.00%
1:502.00%

Margin trading does not always involve additional risks. If a trader has a sufficient amount of own funds, the use of leverage does not necessarily affect his profit and loss. First of all, it is necessary to take into account not the size of the leverage offered by the broker, but the percentage of own funds used in trading, i.e. the actual leverage.

To calculate the actual leverage, it is necessary to calculate the ratio of the total amount of open transactions to the amount of equity capital.

Total amount open transactions
Actual leverage =
Amount of own trading capital

For example, if your trading capital is $10,000 and you open positions of $100,000 (standard lot), the actual leverage will be 1:10. If, all other things being equal, you trade two standard lots ($200,000), the actual leverage will be 1:20.

Most traders refrain from using all their funds in trading, so the leverage provided by the broker is usually different from the actual leverage used by the trader.

Leverage in Forex trading

When trading in the Forex market, traders track price movements in points, i.e. in the hundredth or ten thousandths of the value of a currency pair (depending on the pair). However, price movements of several points are negligible in percentage terms. For example, if the GBP/USD pair grows by 100 pips from 1.9500 to 1.9600, the rate actually changes by only 1 cent.

For this reason, it is necessary to use leverage to purchase large volumes of currency pairs and make some significant profits. If a trader operates with $100,000, a movement of 100 pips will bring him significant profit or loss. Trading on Forex allows the trader to use the actual leverage corresponding to his trading style, character and rules of manipulative management

Risk of excessive leverage

The use of leverage proportionally increases not only the potential profit, but also losses. The higher the percentage of equity capital a trader engages in trading, the higher the risk accepted. It should be noted that the actual leverage plays a major role, rather than the leverage offered by the broker.

Let’s give you an example. Trader A, Trader B has $10,000 in their trading accounts with leverage of 1:100. After the analysis, both traders come to the conclusion that USD/JPY has reached its maximum and should fall in price, and occupy short positions at the rate of 120. Trader A uses actual leverage of 1:50 and sells USD/JPY for $500,000.

Since the current rate is 120, the movement of 1 point for a standard lot is approximately 8.30$, respectively, the movement of 1 point for 5 lots is 41.50$. If USD/JPY rises to 121, Trader A will lose 100 pips, or $4,150, which is 41.5% of the capital in a single trade.

Trader B is more cautious and uses the actual leverage of 1:5.

The sum of the deal opened in this case is equal to $50,000 or half of the standard lot. If USD/JPY grows to 121, the trader’s loss will only amount to $415, or 4.15% of the total trading capital.

The following is a summary table for the above example.

Trader A Trader B
Trading capital10 000$10 000$
Actual leverage1:501:5
Total amount of a trade operation500 000$50 000$
Losses in case of movement against an open position

by 100 points

4150$415$
Loss of capital as a percentage41.5%4.15%
Remaining capital as a percentage 58.5%95.8%

Table 1

Results..

Using the minimum actual leverage, the trader achieves comfortable trading conditions due to the possibility of installing more distant, but reasonable stops, allowing to reduce possible losses.

The use of large leverage can destroy a trader’s account balance in the event of an unfavorable market situation due to large percentage losses. It should be remembered that the trader chooses the leverage according to his needs.

Targets should be reasonable and should not be planned to earn a million by the end of the month or year by using large leverage.