Leverage in Forex allows you to trade a much larger amount than what you have in your trading account.
Every retail trader should carefully monitor trading margins and leverage and how they can affect trading activity.
The concept of leverage is closely related to the concept of margin, a form of debt used by traders and investors to control financial instruments.
A trader can use a deposit in a margin account as collateral to protect their broker from losses incurred by the trader’s activities in the market.
Using a margin account implies that a trader borrows a balance of trading positions from their broker that exceeds their actual deposit balance.
Typically, leverage involves using leveraged financial instruments or capital, such as margin, to increase potential income.
Since the use of leverage, compared to using only equity, increases a trader’s potential for both profit and loss, it is often compared to a double-edged sword.
Leveraged trading seems to be very common these days.
What is leverage?
Imagine that your deposit is $100
You enter a trade with $10, and your broker provides 1:100 leverage.
This means you can hold a position up to $1,000 because for every dollar you put in, your broker will lend you $99 for a total of $100.
With leverage, the trader uses the broker’s funds to control more capital.
Leverage is used in many trading markets, and the amount of funds provided to a trader depends on the broker.
Without a doubt, forex leverage is a great advantage for a trader.
However, it should be used with an understanding of concepts such as risk management and margin.
It is important to remember that leverage does not affect lot size.
However, it does affect the number of lots you can trade based on your deposit size.
Leverage is like lifting a very heavy object.
Some things are too heavy to lift.
But if you have the right leverage, then it becomes possible.
For example, if you have a leverage of 1:100, you can trade a mini-lot (10,000 units) for just 100 units of the base currency.
Leverage gives you great opportunities, but it can also cause problems.
The more leverage you have, the more of your capital you risk.
Let’s look at two traders who have the same $1,000 capital.
Trader A has 1:400 leverage, and Trader B has 1:100 leverage.
Trader A can risk more of his funds per trade than Trader B.
Trader A goes long at 1:400 leverage and buys 1 micro lot (1000 units).
Trader B enters the same long position at 1:100 leverage and buys 1 micro lot.
Since Trader B has a leverage of 1:100, he must have 1/100 or 1% of that of the position size on his deposit.
So this means at least $10 since $10 is 1% of 1000 (1 micro lot).
Trader A has a leverage of 1:400 and therefore requires a trading account of 1/400 or 0.25% of the position size.
Trader A must have at least $2.5 in their account, which is 0.25% of 1000 (1 mini lot).
Leverage can be extremely dangerous.
If your trading account is $1000 with 1:400 leverage, for only $100, you can trade 4 mini lots.
If you spend $100 on one position, you can lose $400, which is 40% of your trading account.
To control a $100,000 position with 1:100 leverage, you only need $1,000 on your deposit.
Now you can manage $100,000 with $1,000.
Let’s say your trade made a profit, and $100,000 turned into $101,000.
If you used 1:1 leverage and entered the trade with $100,000, your profit would be very small and 1% ($1,000 of $100,000).
But if you took leverage of 1:100 and opened a trade with only $1000, your income would be 100% ($1000 of $1000).
But if you suffered a loss, you would lose only 1% of your capital in the first case, and in the second case, you would lose your entire capital.
Leverage also depends on market conditions; the broker can change this in special cases.
For example, many brokers had reduced leverage in preparation for the Brexit referendum (when England voted to stay or leave the European Union).
How to calculate leverage?
Many novice forex traders usually confuse margin and leverage.
Although they are closely related, you must understand the difference between them.
As we already know, leverage gives a trader the ability to control a large position by using a small portion of their funds and borrowing the remainder from their broker.
What is margin? Margin is the portion of your deposit required by your broker to open a position.
The broker can transact with its liquidity providers by using these funds in combination with other client funds.
Forex leverage can be calculated using the following formula:
Leverage = trade size/account size
Let’s take a practical example.
Let’s say you decide to enter a position on a financial instrument with a par value of $100,000.
You only have 2000$ in your trading account.
This way, you will control $100,000 with the $2,000 you have.
Leverage = $100,000 / $2000 = 50
Thus, the effective leverage in this example would be expressed as 1:50.
Let’s say you decide instead to enter a position with the same $100,000 face value, but you have $5,000 in your trading account.
So you will control $100,000 with the $5,000 you have.
Leverage = $100,000 / $5,000 = 20
Thus, the effective leverage in this example would be expressed as 1:20.
Forex brokers may offer leverage up to 1:500 in some cases.
But it is very important to remember that leverage must be used responsibly as it increases potential profits and possible losses.
How to choose the amount of leverage?
There are generally accepted rules that traders must adhere to:
- Don’t use too much leverage.
- Always use a stop loss to limit losses and protect your deposit from significant losses.
- The amount of risk in each transaction should not exceed 1% or 2% of the size of your trading account.
Traders should choose the amount of leverage that will make their trading most comfortable and secure.
If you are a conservative or novice trader, use small leverage that does not exceed 1:100.
Using a given lot size for a certain amount in your trading account is also common practice.
For example, if your deposit is $100, you use a micro lot of 0.01 in each of your trades.
When your trading account reaches $200, you use a lot of 0.02.
Remember that only you determine the size of your leverage.
Your broker may offer maximum leverage, but it is up to you to decide whether you need to use this opportunity.
Use and types of leverage
In the retail market, the presence of leverage in trading benefits traders.
This allows them to control a larger position than they could while making more profit if their view of the market turns out to be correct.
Of course, the disadvantage of using leverage is that the trading risk also increases by the same amount as their profit potential.
Traders usually use the term “effective leverage” to refer to the amount used.
Effective leverage is usually expressed as a reduced ratio of the total net position to the total deposit margin.
Another related term used in the retail market is “available leverage.”
This refers to the amount of leverage still available for a trader based on their current trading positions and the broker’s maximum allowed leverage for a particular account.
In addition, a retail trader’s full amount of leverage is commonly referred to as “maximum leverage.”
Leverage and margin in retail trading
In the retail market, small traders who trade for their portfolios usually place funds in a margin account with their broker.
This margin account will be subject to the maximum leverage normally set by the broker.
Most brokers provide clients with significant maximum leverage, so traders typically use a portion of this leverage to control one or more large trading positions.
This allows the retail trader to increase any profit or loss on their trading positions, and the level of this increase is known as leverage.
To quantify leverage, traders and brokers usually look at leverage ratios.
For example, consider a trader who deposits $5,000 in a margin trading account with a broker.
If a broker allows its clients’ maximum leverage of 100 to 1 or 1:100, then a trader can potentially control a position of up to $500,000 in USD/JPY with an existing $5,000 margin deposit.
If the same trader takes a certain position, say $100,000 in USD/JPY, then the effective leverage is 20:1.
Calculating this leverage ratio gives a trader a useful measure of the risk they are taking about their account size.
Also, it tells them how much free equity they have in their trading accounts before exposing themselves to a margin call.
An example of effective leverage
As noted earlier, “effective leverage” refers to the total position size that a trader controls, given the total amount deposited as a margin with a broker.
This can differ significantly from “maximum leverage.” This concept refers to the maximum amount of a position a trader can have outstanding, given the particular margin deposit held by the broker.
Here is a specific example of effective leverage:
First, consider the situation of a trader with a standard $100,000 USD/JPY lot outstanding and a total account size of $10,000.
Effective leverage is determined by dividing $100,000 by $10,000.
Thus, we get an effective leverage ratio of 1:10.
This effective leverage ratio will increase trading profits and losses by ten times compared to if the trader did not leverage.
Also, if the trader then doubles their position size by purchasing another $100,000 USD/JPY lot to get a total outstanding position of $200,000, using the same $10,000 deposit as margin, then their effective leverage ratio changes to 1:20 as they now control $200,000 with a $10,000 deposit.
This will result in a 20x increase in their trading profits and losses compared to an unleveraged position.
Calculation of effective and available leverage
Many retail forex traders like to keep track of the effective leverage in their trading account and the amount of leverage they can still use in the event of a potentially profitable trading opportunity.
This simple form of leverage analysis helps them manage overall trading risk.
Effective leverage is calculated by dividing the total notional amount of net outstanding positions for each currency pair in which the total amount of margin in the trading account holds the position.
The value of the total notional amount they need for this calculation should be easily provided by their online platform, such as MetaTrader.
It should be summed up for each currency pair.
If a cross-currency position is posted, then the total amount of the base currency must be converted to the accounting currency.
As for synthetic cross positions, it is generally not possible for a trader to get a net long USD/JPY against a short USD/CAD position to go long CAD/JPY, even if the respective USD amounts are equal.
Most brokers treat such cross positions as separate trades against the US dollar.
Leverage and margin are less relevant for the interbank forex market
In the interbank market, currencies are usually traded using credit lines rather than margin accounts.
A dedicated in-house loan officer typically allocates these lines of credit to each potential trading counterparty of the financial institution based on the perceived creditworthiness of that counterparty.
Such interbank foreign exchange transactions usually do not require a margin deposit.
Instead, the margin is effectively distributed by the financial institution to the counterparty as short-term trading credit using a line of credit.
This means that leverage and margin are not specifically used in the interbank market to determine if a client can make a trade if they have a line of credit that will cover the trade.
In addition, most interbank transactions are typically more than US$1 million and may represent significant credit risk.
However, since most spot forex transactions settle in as little as two business days, the actual risk of default on trade during that time among currently creditworthy counterparties is generally considered fairly small by credit analysts.
Forex interbank credit lines are usually expressed in two ways:
- First, they show the total net outstanding forex positions allowed with that counterparty.
- Second, they show the current estimate of the market value of unpaid positions.
As long as the counterparty has enough room on the available line of credit to cover the proposed trade, the interbank market trader usually has the authority to enter the trade without further authorization.
However, suppose there is not enough room in the credit line with the counterparty to cover the proposed forex transaction.
In that case, the interbank currency trader will need special permission from their firm’s in-house loan officer or manager to complete the transaction with that counterparty.
Closing transactions that result in a current position for the counterparty usually do not require these permissions.
It is also important to note that a foreign exchange transaction carried out at the current spot market exchange rate is generally considered to have little or no intrinsic value because it involves the exchange of one currency for the equivalent amount of another.
However, as soon as the market moves, the forex position accumulates profits or losses.
This subsequent value can increase credit risk if the counterparty position loses value or decrease credit risk if it gains value.
The current market value of all outstanding counterparty positions will typically be verified by an interbank trader based on a daily report provided by their firm before agreeing to quote or trade.
This allows you to quickly determine whether transactions with this particular counterparty are allowed under the company’s existing credit lines in the foreign exchange market and in what amount.
Optimizing effective leverage using the Kelly criterion
The main idea behind optimizing effective leverage is usually to maximize the growth of your trading account without risking a complete loss of your funds.
Too many novice traders have noticed that their trading account balances quickly drop to zero after taking on more risk than they could reasonably afford.
Sound risk management practices should help the trader avoid this unfortunate situation.
Also, paying close attention to effective leverage will be very helpful in this regard, as it helps maintain acceptable levels of trading risk.
Several financial theorists have addressed this important issue of risk and money management.
One of the most famous is the mathematician J L Kelly, who came up with the so-called Kelly criterion while working at Bell Labs in 1956.
Financial market traders often use his famous formula to help optimize their odds in the long run.
Those traders who want to use the concept of leverage optimization usually calculate the following formula for their intended trading strategy:
L=(ER)/V
This is to calculate the amount L, which is the optimal leverage you should aim for in your trading account.
This L value will equal the ideal ratio of the total position size in your account to the amount you have deposited into it to use as a margin when using optimal leverage, as defined by Kelly.
The term (ER) represents the expected excess return of your trading strategy.
In this equation, E is the expected return, R is the risk-free interest rate, and the difference is the excess return.
The term V in the denominator of the equation above refers to the expected statistical variance of your strategy’s excess return or amount (ER).
For example, consider a trading strategy you have tested for which you have an expected annual return E of 35%, or 0.35, and an annual risk-free interest rate, R, of 2%, or 0.02.
If the variance V of your expected excess return (ER) is 0.01, then the optimal leverage L for your account using this strategy would be:
L = (0.35-0.02) / (0.01) = 33
Thus, this example of calculating the Kelly Criterion shows that you should aim for an ideal effective leverage ratio of 1:33 if you plan to follow this leveraged investment strategy with the above parameters.
In practice, this would mean that a retail trader who deposits $10,000 into their trading account and intends to use a trading strategy with the above-expected return will aim to use their account up to a total position size of $330,000 using their chosen trading strategy.