What is Leverage And Should You Be Using It?
As a novice trader, the mention of leverage might have your head spinning on your shoulders. Why is there no simple explanation? Expert traders try to explain it but you usually end up feeling more baffled than before.
Leverage is one of the most misused and misunderstood terms in Forex trading. Many Forex traders use leverage to profit from small price fluctuations in currency pairs. But leverage can amplify profits and losses.
Yet many thousands of Forex traders are trading every day, with little to no grasp of the basics of leverage.
In this chapter, we are going to do our best to help you to understand leverage in Forex. With this knowledge, you can then make an informed decision as to whether to use leverage or not.
What Is Leverage?
The most commonly used explanation for leverage is:
“Leverage is the use of borrowed funds to increase one’s trading position beyond what money is available from a trader’s existing cash balance alone”.
Let's start with a simple explanation?
Yes? OK, here goes.
Suppose you have treated yourself to a day out at the races with your friend John. You’ve been looking forward to it for weeks. You’ve saved a bit of money and you’re excited about having some fun betting on the horses.
Let’s say you have £100.00 to spend.
The day arrives and off you go.
It all starts well and you have a few winners. Then luck turns against you and horse after horse loses. Your £100.00 has gone. Oh, dear. Your mate John has had the luck of the devil. He’s made a nice profit and he’s feeling flush. So, he shoves £100.00 into your hand and says, “Carry on betting mate. Your luck will turn any minute now”.
The next race wins but the following four races lose. Now you have lost the £100.00 that John lent you.
So, let me ask you, how much have you lost and how much do you owe? It’s not rocket science, is it? You have lost £100.00 and you owe £100.00 to your nice mate John.
In other words, you have lost 200% of your starting capital.
In effect, what you were doing with John’s £100.00 was betting using borrowed money.
In essence, my friend, this is what leverage is all about. It means you are in effect betting using the brokers' money. They are giving you a temporary loan so you can magnify your trading profits. That sounds pretty generous of them, doesn’t it? Er, well how about the other side of the coin?
It magnifies your losses too.
In simple terms, leverage of 100:1 from your broker means for every £1.00 you have in your account, you can place a trade for up to £100.00. So, £1000.00 in your account means you are controlling £100,000 if you use a 100:1 ratio of leverage! Wow! Really? That’s a lot of money.
No wonder this often seems confusing. When brokers describe 100:1 as 1:1 leverage, it sounds quite tiny doesn’t it? But a £100,000 leverage of 1:1 is 100% profit OR loss.
Why is Leverage Attractive to Forex Traders?
Imagine you have £1000.00 in your account and you don’t use leverage.
You want to place an order for USDJPY. You are selling the U.S. Dollar and buying the Japanese Yen. The price for the yen is 102.50.
You can buy 1000 times 102.50 0r 102,500 Japanese Yen.
Price then drops to 102.00 and you exit the trade for a profit. How much have you won?
The calculation is –
Divide 102,500 (the starting amount in yen) by the new exchange rate of 102. This gives you £1,004.90.
You have made £4.90 profit.
(You won’t need to do this calculation yourself, but it might help to see how it is calculated)
Now, let’s do the same exercise with 100:1 leverage
With 100:1 leverage you can buy 100,000 x 102.50.
You close the trade at 102 and you have made a profit of £490.20. With a £1000.00 account, you have increased your balance by almost 50%.
Well, this sounds great, doesn’t it? But, let’s not get carried away. Had the trade gone the other way, resulting in a loss, you’d have wiped out almost 50% of your account. A couple of those bad boys and it's game over.
Over leveraging your account puts you at risk of a margin call. If you recall in chapter 3, margin is a portion of your account balance with the broker set aside so you can trade. Your margin depends on whether open trades are in profit or loss.
If you get a margin call from your broker, it means there's not enough money in your account to cover open positions. You must close them or add new funds. At a certain point, your broker has the right to close your open trades.
It’s easy to think you can get away with it. But, as a novice trader, and with a small account, it doesn’t take much to wipe out your account. Yes, you may get lucky. You may have some generous wins. But, in reality, it’s a dangerous route for an inexperienced trader.
Let’s look at a leverage scenario outside of Forex.
Imagine you are buying a house. You have a £20,000 deposit. The mortgage takes this as 20% towards the loan. They then provide 80% of the money at 100/20 or 5 to 1.
The house you can afford is £100,000.
Imagine the mortgage broker offering you say 400:1. Now, for your £20,000, you can buy an £8,000,000 house. Yes, eight million pounds for a £20k deposit.
Can you imagine high street lenders offering clients this deal? The house would be repossessed in the first month. I can’t even imagine what the mortgage payments would be on eight million pounds! You’d be bankrupt faster than you can say nuts. Because, yes, it’s nuts to even think about this as a possibility isn’t it.
Well, this is leverage. And that’s the kind of deal many brokers will offer novice traders before they even know what a pip is!
We recommend that as a novice trader it is preferable to use the lowest leverage available. We’re not saying you shouldn’t use leverage. You have a personal choice. But, for novice traders, it’s always a good plan to reduce risk as much as possible.
Under new ESMA regulation, the maximum available leverage for UK retail traders is 30:1
It’s also worth noting some brokers do not offer leverage at all.
Please do check the leverage for the broker in your country as many brokers across the world are limiting leverage options now.