How Leverage Is Used In Forex Trading

Leverage is widely used in all global markets, not only to obtain physical assets such as real estate or cars but also to trade financial assets such as equity and foreign exchange or foreign exchange.

Forex trading by retail investors has grown significantly in recent years, thanks to the rise of online trading platforms and the availability of cheap credit. The use of leverage in trade is often equated with a double-edged sword because it increases profits and losses. This is very relevant in the case of forex trading, where a high level of leverage is the norm. The examples in the next section illustrate how leverage increases returns for profitable and unprofitable trade.

Example of Forex Leverage

Let's assume that you are a U.S. based investor. and have an account with an online forex broker. Your broker provides the maximum leverage allowed in the US on a major currency pair of 50: 1, which means that for every dollar you install, you can trade $ 50 of the major currency. You place $ 5,000 as a margin, which is a guarantee or equity in your trading account. This implies that you can initially place a maximum of $ 250,000 ($ 5,000 x 50) in a currency trading position. This amount will obviously fluctuate depending on the profit or loss you make (note: this and the example below are gross commissions, interest, and other fees). 

Example 1: Long USD / Short Euro. Number of trades = EUR 100,000

Assume you start the trade above when the exchange rate is EUR 1 = USD 1.3600 (EUR / USD = 1.36), because you are bearish on the European currency and expect to decline in the near future.

Leverage: Your leverage in this trade is more than 27: 1 (USD 136,000 / USD 5,000 = 27.2).

Pip Value: Because the euro is quoted to four places after the decimal, each "pip" or base point in euros equals 1/100 of 1% or 0.01% of the amount traded from the base currency. The value of each pip is expressed in USD, because this is a counter currency or quote currency. In this case, based on the number of currencies traded € 100,000, each pip is worth $ 10. (If the amount traded is € 1 million versus USD, each pip will be worth $ 100.)

Stop-loss: When you test conditions related to forex trading, you set a tight stop-loss of 50 pips on your long USD / short EUR position. This means that if stop-loss is triggered, your maximum loss is $ 500.

Profit / Loss: Fortunately, you have beginner luck and the euro falls to the level of EUR 1 = USD 1.3400 in a few days after you start trading. You close the position with a profit of 200 pips (1.3600 - 1.3400), which translates to USD 2,000 (200 pips x USD 10 per pip).

Forex Mathematics: In conventional terms, you sell a short of € 100,000 and receive $ 136,000 in your opening trade. When you close a trade, you buy back the euro that you shorted at a cheaper rate of 1.3400, paying $ 134,000 to € 100,000. The $ 2,000 difference represents your gross profit.

Leverage Effect: By using leverage, you can generate a 40% return on your initial investment of $ 5,000. What if you only trade $ 5,000 without using leverage? If so, you will only shorten the euro equivalent to $ 5,000 or € 3,676.47 (USD 5,000 / 1.3600). This much smaller number of transactions means that each pip is only worth USD 0.36764. Closing the short euro position at 1.3400 will produce a gross profit of USD 73.53 (200 pips x USD 0.36764 per pip). Using leverage thus increases your return exactly 27.2 times (USD 2,000 / USD 73.53), or the amount of leverage used in trading.

Example 2: Short USD / Long Japanese Yen. Number of trades = USD 200,000

The 40% profit on your first forex leveraged trade has made you want to do more trading. You turn your attention to the Japanese yen (JPY), which trades at 85 to USD (USD / JPY = 85). You expect the yen to strengthen versus the USD, so you start a short USD / long yen position in the amount of USD 200,000. The success of your first trade has made you willing to trade in larger amounts because you now have a margin of USD 7,000 in your account. Even though this is far greater than your first trade, you get the convenience of the fact that you are still in the maximum amount that you can trade (based on 50: 1 leverage) of USD 350,000.

Leverage: Your leverage ratio for this trade is 28.57 (USD 200,000 / USD 7,000).

Pip Value: Yen is quoted to two places after the decimal, so each pip in this trade is worth 1% of the base currency expressed in the quote currency, or 2,000 yen.

Stop-loss: You set a stop-loss on this trade at the level of JPY 87 to USD, because the yen is quite volatile and you don't want your position to be stopped by random noise.

Remember, you are a long yen and a short USD, so ideally you want the yen to appreciate versus USD, which means you can close your short USD position with a smaller yen and pocket the difference. But if your stop-loss is triggered, your losses will be very large: 200 pips x 2,000 yen per pip = JPY 400,000 / 87 = USD 4,597.70.

Profit / Loss: Unfortunately, reports of a new stimulus package launched by the Japanese government caused the yen to weaken rapidly, and your stop-loss was triggered the day after you trade long JPY. Your loss, in this case, is USD4,597.70 as explained previously.

Forex Mathematics: Conventionally, mathematics looks like this:

Opening position: Short USD 200,000 @ USD 1 = JPY 85, e.g. + JPY 17 million

Closing position: Triggers stop-loss results in short positions of USD 200,000 covered @ USD 1 = JPY 87, e.g. - JPY 17.4 million

The difference of JPY 400,000 is your net loss, which with an exchange rate of 87, managed to become USD4,497.70.

Leverage Effect: In this case, using leverage increases your losses, which amounts to around 65.7% of your total margin of USD 7,000. What if you only shorten USD 7,000 versus yen (@ USD1 = JPY 85) without using leverage? This smaller number of transactions means that each pip is only worth JPY 70. A stop-loss triggered at 87 will result in a loss of JPY 14,000 (200 pips x JPY 70 per pip). Using leverage thus increases your losses exactly 28.57 times (JPY 400,000 / JPY 14,000), or the amount of leverage used in trading.

Tips When Using Leverage in Forex Trading

While the prospect of making large profits without losing too much of your own money may be tempting, always remember that too high a level of leverage can cause you to lose your clothes and more. Some security precautions used by professional traders can help reduce the inherent risk of foreign exchange trading: 

• Close Your Losses. If you hope to make a big profit someday, you must first learn how to keep your losses small. Close your losses to manageable levels before they disappear and drastically erode your equity.

• Strategic Stop Use. Strategic stops are very important on the 24-hour forex market, where you can sleep and wake up the next day to find out that your position has been affected by movements of several hundred pips. Stop can be used not only to ensure that losses are limited but also to protect profits.

• Don't handle it. Don't try to get out of the losing position by doubling or leveling it. The biggest trading loss had occurred because a rogue trader was stuck in his weapon and continued to add to the losing position until it became so big, it had to be canceled with a big loss. The merchant's view may ultimately be true, but it is generally too late to make up for the situation. It's far better to cut your losses and keep your account alive to trade on another day, rather than being left hoping for a miracle that won't happen that will reverse the big losses.

• Use Leverage that matches your level of comfort. Leverage 50: 1 means that a 2% adverse step can erase all your equity or margin. If you are a relatively cautious investor or trader, use the lower level of leverage that you like, maybe 5: 1 or 10: 1.

The Bottom Line

While the high level of leverage inherent in foreign exchange trading increases returns and risks, our example shows that by using several precautions used by professional traders, you can help reduce these risks and increase your chances of increasing returns.

How to Choose a Forex Broker?
TopAsiaFx.com helps you compare and choose your preferred Forex Broker. We suggest keeping the following checklist in mind when making your decision:

• Is the Forex Broker regulated?
• Account Details: Ideally, your broker should offer either a selection of account types or some element of customizability. Competitive spreads and easy deposits/withdrawals are good indicators too.
• Number of Currency Pairs offered: The variety of currency pairs on offer, as well as the quantity, should be considered (the more of both, the better).
• Availability of Customer Service.
• Quality of the Trading Platform: look for a platform that is easy to use, straightforward and offers a collection of technical and analytical tools to enhance your trading experience.

Rank	Broker Name	Special Offer	Minimum Deposit	Spread	User Score	Maximum Leverage	Regulation	Start Trading
1	NordFX	55% Deposit Bonus	$10	0.0 Pips	96	1:1000	VFSC	Open Account
2	SGT Markets	Refer a friend $10	$500	0.0	95	1:400	IFSC	Open Account
3	OctaFX	50% Deposit Bonus	$100	0.4	94	1:500	IBC	Open Account
4	Exness	No	$1	0.1	93	1:2000	FCA,CySEC,IBC	Open Account
5	IC Markets	No	$200	0.0	92	1:500	ASIC	Open Account
6	Tickmill	$30 Welcome  Account	$100	0.0	91	1:500	FSA,FCA	Open Account
7	Axiory	$50 Deposit Bonus	$200	0.0	90	1:400	IFSC	Open Account
8	Justforex	100% Deposit Bonus	$1	0.0	89	1:3000	IFSC	Open Account
9	ThinkMarkets	No	$250	0.4	88	1:400	ASIC,FCA	Open Account
10	XM	$30 Welcome Account	$5	0.0	87	1:888	ASIC,FCA,IFSC	Open Account
11	FBS	$50 Welcome Account	$1	0.0	86	1:3000	IFSC	Open Account
12	HotForex	No	$5	0.0	85	1:1000	INC	Open Account