Although the concept of leverage is relatively easy to grasp, it is very often misused. It is essential for beginners to understand how it increases their risk in Forex trading and how to use it responsibly.
What is Leverage?
The textbook definition of leverage is using a smaller amount of capital to gain exposure to larger trading positions via the use of borrowed funds. In the case of Forex trading, money is usually borrowed from a broker. Forex traders often use leverage to profit from relatively small price changes in currency pairs.
Leverage is always expressed as a ratio. For example, a leverage ratio of 100:1 means that the necessary margin required to open and maintain a position is one-hundredth of the transaction size. So, with 100:1 leverage, a trader would need 1,000 USD to control a position size of 100,000 USD.
Why Do Traders Use Leverage?
Without leverage, Forex trading with small amounts of money (say 1000 USD or so) would not be very profitable because the price movements in Forex pairs are so small.
For example, if you open a trade with 1,000 USD without leverage, for every pip lost or gained, the theoretical loss or gain amounts to $0.10. And if you trade on an instrument such as the EUR/USD, which has an average daily range of only around 70 pips, your maximum profit or loss will be only 7 USD.
However, if you use leverage of 1:100 with a deposit of 1,000 USD, your position size is now 100,000 USD. For every pip movement, your theoretical loss or gain will now be 10 USD. Again, if you were trading on the EUR/USD and the market moved 70 pips in a day, you would stand to gain or lose 700 USD.
Beginners must understand that leverage only applies to the allotted capital used in a trade. It does not apply to the entire trading account. So if you have 10,000 USD in your trading account and open a trade with 1,000 USD, the leverage will only apply to that 1000 USD. However, this doesn’t mean that your trading account won’t be affected by leverage if you lose badly on a trade. Any losses you make that are not covered by your margin will be taken from your trading account. In some cases, one bad trade can wipe out entire trading accounts.
Margin and How It’s Different from Leverage
CFD trading is often referred to as “trading on margin” or “margin-based trading.” Margin is another way of defining the leverage you can borrow from a broker.
Margin is defined in percentage terms. If you have a leverage of 10:1, your required margin will be 10%. If you have 400:1 leverage, your margin will be 0.25%. So, the margin refers to the percentage of the trader’s overall cost.
For example, if you are required to deposit 1% of the total transaction value as margin and intend to trade one standard lot of USD/CHF, equivalent to 100,000 USD, the margin required would be 1,000 USD.
The relationship between margin and leverage:
| Margin | Leverage |
| 10% | 1:10 |
| 5% | 1:20 |
| 3.33% | 1:30 |
| 2% | 1:50 |
| 1% | 1:100 |
| 0.5% | 1:200 |
The Risks of Using Leverage
Leverage is a very appealing aspect of trading, as winnings can be multiplied immensely. But it is a double-edged sword, and losses can be multiplied just as easily.
Continuing with the example above, if you deposit 1,000 USD on a trade with a leverage of 1:100, which results in a position size of 100,000 USD, and the market goes against you by 70 pips, you would lose 700 USD, which is 70% of your initial deposit. However, if you hadn’t used leverage, you would have lost only 7 USD, which is 7% of your capital.
Traders should implement sound risk management strategies when trading on leverage.
Most Forex traders implement strict trading styles that include the use of stop-loss orders to limit potential losses. A stop-loss order is an instruction given to the broker specifying the maximum loss that can be incurred on a position. It ensures that your position is closed at a certain price level and prevents you from losing more than you can afford. In this way, you can restrict the losses on any trade.
How Much Leverage Should I Use?
Traders should choose the level of leverage that makes them most comfortable. Beginner traders will likely be more conservative in their use of leverage, limiting it to 5:1 or 10:1 for Forex trading. Only once traders have more experience and know how to limit their losses should they move onto higher levels.
Some traders – such as professional scalpers – are comfortable with much higher risk and may even trade with very high leverage levels of up to 400:1 or 500:1. But professional traders tend to have rigorously tested risk management systems – and the extraordinary discipline needed to follow them to the letter.
Is there a Limit on the Level of Leverage Brokers Can Offer?
Leverage varies from 1:20 up to 1:3000 depending on the broker and the regulation to which the broker adheres. Since 2018, regulators in the UK and Europe have introduced leverage restrictions to protect traders’ interests because beginner traders were losing so much money. As a result, FCA and CySEC-regulated brokers can only offer a maximum leverage of up to 30:1 on Forex pairs. In 2021, the Australian Securities and Investments Commission introduced a limit of 30:1, and the Securities Commission of the Bahamas introduced a limit of 200:1. In the years to come, we expect more regulators to follow suit.
Traders in Europe, the UK, or Australia looking to trade with higher leverage will have to find an offshore broker. Offshore brokers are often regulated by more relaxed authorities, such as Seychelles’ Financial Service Authority or the Financial Services Commission of Mauritius. Offshore brokers often allow leverage of 1:1000 and sometimes up to 1:3000.
Overview
Leverage can be used successfully and profitably with proper management. Like any sharp instrument, leverage must be handled carefully—once you learn to do this, you have no reason to worry, and you will be able to use it skillfully to your advantage. The best way to learn how to use leverage is with a demo account, these can be opened for free at all good brokers. Demo accounts allow beginners to experiment with different levels of leverage without risking any money at all.
