In the Forex market, there are long-term traders, medium-term traders, and scalpers. Scalpers often aim at small amounts of pips in profit as they execute multiple trades in a day. Without a large account balance, these profits may seem insignificant when expressed as a dollar amount. Leverage allows these traders to take on positions larger than their account equity. This way, they can magnify their profits exponentially.
Leverage allows a trader to trade the forex market with more money than they hold in their account. Essentially, a broker lends the money to the trader, allowing them to trade on leverage. Nowadays, almost all forex brokers offer leverage to their clients. However, its maximum limit is determined by the regulatory body of their jurisdiction. Most brokers will offer a maximum leverage of 50:1 for major pairs, but some go as high as 1000:1.
For instance, let’s say you have $100 in your brokerage account. You wish to trade a micro lot of the EURUSD pair. A micro lot consists of 1,000 units, which means you require $1,000 to buy the micro lot. Your broker allows you to buy the 1,000 units worth $1,000 even though you only have 100 bucks in your account. This is leverage of 10:1, which is within the 30:1 maximum limit offered by most brokers for major pairs.
Why would a broker offer their clients leverage? Well, the value of currencies, especially major currencies, is not likely to drop to zero rapidly. This is why brokers can be confident that traders will not be faced with huge, irrecoverable losses. However, there is still that risk, albeit low, which is why brokers put a cap on the maximum leverage they offer.
The volatility of the traded asset also plays a role in the amount of leverage offered. If you look at Bitcoin, for instance, it has been known to be extremely volatile, its price fluctuating in the hundreds or thousands in just a short period. For this reason, its maximum leverage is capped at 2:1. The most traded currency pair, EURUSD, in contrast, only fluctuates about 10% in value every year. This is why brokers offer leverages of up to 30:1 or higher.
For a broker to offer you leverage on a trade, they require you to have a percentage of the trade’s value in your account. This minimum deposit is called margin. For instance, a broker offering a 30:1 leverage requires you to have 3.34% of the total value of the trade. Margin and leverage are related as follows:
Margin = 1/leverage.
Leverage = 1/margin.
Table showing leverages and their corresponding margins.
From the table above, it is clear that the higher the margin you take on, the riskier it is. At higher margins, small price movements against your position are enough to blow your account.
Definition of terms
Equity would refer to the standing account balance of your trading account if all your open positions were closed immediately. Therefore, it includes all accrued profits and losses as at the time of checking.
This is the amount left in your account for use as a margin for opening new trades. It takes your equity and subtracts the amount that is being used as a margin for your open trades.
When your account balance falls below the margin required by your broker to keep all your trades open, they tend to close some of your positions. This way, they make sure your equity is sufficient to provide a margin for the remainder of your open positions.
How to choose a suitable leverage
We’ve established that forex pairs enjoy high leverages, some brokers going as high as 1000:1. It may be tempting to use high leverages to multiply your profits. However, this comes with high risks, too, as slight price movements against you can multiply your losses, sometimes even blowing up your account. You may use stop losses to offset this risk. However, when markets are highly volatile, slippage can cause your stop losses not to be executed.
In 2015, the Swiss franc (CHF) instantaneously rose against all other currencies by more than 20%. For the traders who didn’t have guaranteed stop losses, their stop losses did not come into effect. Trading was also suspended for over an hour, which meant traders could not close their positions or open new ones.
At leverage of 5:1, a 20% price movement against your position is enough to blow your account. When this flash crash happened, any traders who were short on the CHF with leverages above 5:1 lost their accounts that day.
When choosing your leverage, you should consider the volatility of the pair you’re trading. Major pairs have high liquidity, and with those, you can risk taking on higher leverages. Minor pairs are often pegged or manipulated, so you should use lower leverages when trading them.
Additionally, you should consider the maximum drawdown your account can take on and recover. With this in mind, you can calculate the maximum risk you can take, which will limit the leverage you can take on. As a rule of thumb, you should never risk more than 1% of your equity on a single trade. Therefore, if you have a fixed stop loss, you can calculate the maximum amount of leverage you can take on for each of your trades.
Leverage allows you to trade with more than your equity. Essentially, your broker will need you to raise a minimum deposit called a margin, and then they’ll loan you the rest of the money to complete your order. Leverages may lead to multiplied profits, but the flip side is also true – any losses will be similarly multiplied. For this reason, it is important to exercise caution when taking on leverage.