How Does Leverage Work in The Forex Market?
There are many terms and definitions bandied about in the world of foreign exchange with a number of concepts that traders need to know and understand before they should even consider opening a trading account. One such concept or tool in the Forex trader’s arsenal is leverage, which if used correctly, can significantly amplify their returns.
In the world of Forex, traders use forex leverage to profit from the vagaries and movements in currency markets and because price changes in currency spreads are so minuscule, currency leverage is used to increase the size of the transaction and thus the lucrativeness of each trade.
Leverage by definition is a loan or debt and in the Forex market the leverage available to traders is among the highest available. This leverage is provided to traders by the broker managing their FX trading account and in the form of a margin loan. The total currency leverage offered to traders differs by broker but typically it ranges from about 50:1 to 500:1 depending on the lot being traded by the Forex trader. The typical amount traded when it comes to currency pairs is 100,000 units and a trade of this kind usually carries a forex leverage requirement of 50:1 or 100:1. Leverage ratios of 200:1 and above are usually for smaller currency positions up to $50,000.
The beauty of leverage in Forex markets is that in order to trade $100,000 worth of currency at very low margins, a trader typically only need deposit $1,000 in their trading accounts. In this scenario, the leverage provided to traders is 100:1 and is far larger than the more common leverage ratios provided for other financial instruments such as equities or futures.
It is important to note that although leverage at levels of 100:1 and greater seem incredibly high and carries an overwhelming amount of risk, currency prices fluctuate by less than 1% during a typical day of trading, thus mitigating some of variability. Share markets fluctuate far more than currency markets and brokers cannot offer as much leverage to traders as this would expose them to far too much risk.
Understanding Forex Leverage
Traders need to completely understand how forex leverage can impact on their Forex trades BEFORE even contemplating their first trade. While high leverage as a trading strategy has the ability to earn amazing returns in the Forex market, leverage is a double edged sword as it can amplify losses. Should a trader speculate on a particular currency and it moves in the wrong direction, leverage will significantly escalate the poential losses sustained by the trader. It is therefore recommended that risk management tools be applied to help mitigate some of the loss risks,
It is highly recommended that Forex traders adopt strict trading techniques and always utilise tools such as stop losses and limit orders that can put a significantly minimise the losses sustained from a trade gone bad. Some Forex brokers offer guaranteed stops free of charge while other companies will charge users a small fee. Traders often baulk at any additional fee, especially early in their trading careers. It might be a good idea to choose a broker that offers free stop losses. However, if for whatever reason a broker offering this service for free is hard to come by, it is recommended to just bite the bullet and pay for this additional security. It is but a small price to pay to keep your capital safe.
What is Margin Required?
Margin required is the how much money that is needed in your account to open a position. If the leverage is 100:1, you will need $1,000 to control a position of $100,000. The $1000 you have deposited in your account is the ‘margin requirement to have access to the leverage.
Understanding Margin Rate
While most brokers express the amount of leverage offered as a ratio; ie 500:1 to 200:1 some brokers use margin rate rather than leverage for the amount of money that will be required to open a position. Margin rate is express as a % rather than ratio. This % is the amount of the position you will take. For example 2% or 0.5%. If you know your margin rate, then the maximum leverage can be calculated. The easiest conversion would be if the margin required is 1% then the maximum leverage available is 100:1.
The table below shows the Margin Conversion.
|Margin Required||Maximum Leverage|