Leverage is a concept that allows traders to open positions of much higher value than their account balance.
Leverage decreases required margin levels and is one of the main reasons that makes Forex trading so popular.
It is important to note that leverage is referred to as a ‘double-edged sword’, as it can amplify profits as well as losses.
Leverage is a common concept that is used in many different aspects of society. Lets have a look at a common example, below.
You are looking to buy a house with a value of £200,000. You are seeking a mortgage from the bank to buy this house.
The bank asks for 10% of the purchase price up-front, with the remainder to be paid back via a ‘finance plan’.
So, you will receive a total of £200,000 from the bank, by paying them £20,000 up-front, and the other £180,000 (+ interest) paid in instalments.
This is a common example of leverage, as you have ‘levered‘ your £20,000 to purchase a house worth £200,000.
Forex brokers use leverage in a similar way. As a trader, you can leverage your position with via your brokers credit. By doing this, you can amplify both profits and/or losses.
You are able to open (as well as keep open) these positions permitted you have enough free margin. Different leverages have different margin requirements to be able to open a position.
Typically leverage will vary quite widely from anywhere between 2:1 up to 400:1. This means that for every 1 unit (of currency), you are able to manage positions anywhere between 2 to 400 times bigger than the funds that you have in your account.
Trading at a different leverage requires a different amount of margin to be able to open the same position.
You can see in the table below how much margin is required to open a position at different leverages.
|400:1||0.25% of total transaction|
|200:1||0.50% of total transaction|
|100:1||1.00% of total transaction|
|50:1||2.00% of total transaction|
|30:1*||3.33% of total transaction|
|20:1||5.00% of total transaction|
*ESMA Limit. Therefore FCA regualted brokers offer this as a maximum for retail traders.
A trader wants to open a GBP:USD position with a volume of 1 standard lot, at a leverage of 100:1.
How much margin is required to open this position?
1 standard lot (100,000 units) is equivalent to £100,000 (Pound sterling vs US Dollar).
£100,000 * 1% (0.01) = £1,000 Margin Required
The trader has an account balance of £5000. How much free margin do they now have left?
£5,000 (Account Balance) – £1,000 (Used Margin) = £4,000 (Free Margin)
What leverage should you use?
This is a really important question that is key for your trading success. Leverage is a tool that needs to be managed effectively and wisely.
Professional traders usually don’t use leverage any higher than 20:1. This is still a relatively high leverage, and is a lot more manageable than a leverage of 200:1.
Large leverages, such as 200:1, are considered very risky as any slight movement in price may significantly decrease your amount of free margin rapidly.
This may cause your broker to automatically liquidate (close) your positions, protecting you from losing more.
Due to recent regulations, European brokers can now only offer a leverage of 30:1 for retail traders.
This is because many retail traders were using the largest leverages possible, which were wiping out the funds in their accounts in a short amount of time! Therefore, in order to protect retail traders, the ‘European Securities and Markets Authority’ (ESMA) put in place a maximum leverage of 30:1.
Retail traders, are loosely defined as someone trading from home with no specific industry experience.
- Leverage is a concept that allows traders to open positions of much higher value than the cash that is in their accounts.
- Leverage decreases required margin levels and it is one of the main reasons that makes Forex trading so popular.
- Leverage is commonly referred to as a ‘double-edged sword’, as it can amplify profits as well as losses.
- Different leverages require different margins to be able o place a trade.
- Leverage needs to be managed effectively and wisely!
- Due to recent regulations, European brokers can now only offer a leverage of 30:1 for retail traders.