When it comes to forex trading, leveraged trades open the door for significant profits beyond what a trader’s current capital allows. However, leverage also increases the impact of losses and, without a sound understanding of the process, can leave traders with almost nothing.
Learning the ins and outs of leveraging can allow forex traders to take larger positions and maximize potential returns, especially with funds from FX brokers with high leverage. In this guide, a basic overview of leverage is provided, as well as how it might be used in a potential trade, and some important tips to mitigate risks.
What Is Leverage?
Leverage is a financial tool that allows forex traders to control a larger position than is possible with the funds currently in their account. To do this, traders will borrow funds, usually from FX brokers with high leverage.
In particular, leverage is the amount of borrowed money an individual trader puts up to open or sustain a trading position. On the other hand, the margin is the amount of their own money a trader must deposit to make a leveraged trade, acting as collateral for the borrowed funds.
Leveraging funds increases the position size and, in turn, the potential profits or losses. Borrowing money from a broker or bank doesn’t eliminate these risks, and a sound risk management strategy is paramount, especially when trading with FX brokers with high leverage.
This strategy of using borrowed funds in conjunction with one’s own capital is called margin-based leveraging.
Important Terms for Forex Traders Using Leverage
As discussed, forex traders using margin-based leverage will still need to meet the initial margin/deposit margin requirement, as well as the maintenance margin set by their broker.
Margin Requirement – This is set by the broker and determines the minimum amount of their own capital a trader must put up as collateral. It is expressed as a percentage of the total position size. FX brokers with high leverage may require higher margins.
Initial Margin/Deposit Margin – As determined by the margin requirement, initial margin or deposit margin refers to the amount of their own money a trader contributes to a leveraged position.
Maintenance Margin – The amount of money a trader must have in their account to keep a leveraged position open. This acts as a safeguard for both the trader and broker in the event of ongoing losses. The Financial Industry Regulatory Authority (FINRA) currently sets the maintenance margin at 25% in the US, but individual brokers and brokerage firms will likely have their own requirements which may exceed this. If the equity in a trader’s account falls below this level, the broker may issue a margin call.
Margin Call – Issued by FX brokers with high leverage and low leverage alike, a margin call requires the trader to deposit additional funds to meet the maintenance margin. If the maintenance margin cannot be met, a broker may decide to liquidate certain positions.
How to Calculate Leverage
Leverage is expressed as a ratio and is determined using the following calculation, with the amounts expressed as monetary values in the forex trader’s base currency:
Margin-Based Leverage = Total Value of Position / Margin Requirement
Margin and leverage have what’s called an inverse relationship; the higher the margin, the lower the overall leverage ratio.
1. Based on their research and experience, a trader is planning to conduct a trade with a total value of 50,000 USD. Their FX broker with high leverage has set their margin requirement at 1%.
2. One percent of 50,000 (50,000 x 0.01) is 500, so the initial margin that the trader will need to provide is 500 USD.
3. Putting these amounts into the calculation, the trader is left with a margin-based leverage that equals 50,000/500.
4. Through simplifying this calculation, the margin-based leverage can be expressed as the ratio 100:1. This means that for every 1 USD a trader provides, they can control a position of 100 USD.
A trader does not need to put up the exact margin requirement to open a leveraged position. They can provide more of their own funds if they see fit. If a trader only wishes to provide the margin amount, they may wish to work with FX brokers with high leverage.
Conducting a Leveraged Trade:
Though it’s helpful to know the leverage ratio, traders must also know how it affects their trades. An example of a successful leveraged forex trade is:
- The exchange rate for US dollars to Japanese yen is currently at 110.00 (1 USD = 110 JPY). A trader expects the JPY to appreciate in value against the USD.
- The trader wants to control a position of 500,000 JPY. Their total position in USD will be 500,000 JPY / 110.00 = 4,545.45 USD. However, they only have 1200 USD in their account and, as such, decide to work with FX brokers with high leverage.
- Their broker has set a margin requirement of 1%, so they calculate 4,545.45 x 0.01 = 45.45 USD. The trader pays their broker 45.45 USD as the initial margin and the broker puts up 4500 USD. The 25% maintenance margin requires the trader to have 1134 USD left in their account.
- The trader opens a leveraged position of 500,000 JPY with their 45.45 USD and the borrowed amount from the FX brokers with high leverage. Using the margin-based leverage calculation, their leverage stands at 4,545.45 / 45.45 = 100:1.
- The trader was correct in their assumptions and the JPY appreciates. The new exchange rate stands at 108.00. So, the new value of their position is 500,000 JPY / 108.00 = 4,629.63 USD
- The trader’s profit is the new total value of the position less the funds they borrowed from the broker and their initial margin requirement. So, 4,629.63 USD – 4,545.45 USD = 84.18 USD. The trader closes their position.
The trader amplified their exposure through borrowed funds and was able to make a much larger profit than the 22 USD they would have received using only their available 1200 USD, and that’s without considering maintenance margins. In the context of profits, the impact of leverage becomes more pronounced when working with FX brokers with high leverage and considering larger positions or smaller market movements.
However, in the context of losses, the trader also stood to lose a larger amount of money. If the losses exceeded the amount available in the trader’s account, an FX broker with high leverage would likely have issued a margin call for the trader to add funds to their account or liquidated the position to prevent their account balance from going negative. This is a common practice to ensure a trader doesn’t incur debts larger than their total capital.
Practical Tips for Forex Traders Using Leverage
Since leveraged trades increase the risks associated with forex trading, there are some common tactics traders use to make the best decisions and reduce the risk of losses. These include:
Maintaining Low Leverage Levels – Lower leverage provides greater flexibility when deciding how long to keep a position open and whether to increase or decrease the size of that position. Novice traders in particular may benefit from a more favorable leverage ratio so they can learn and adapt to the forex market without excessive risk. However, FX brokers with high leverage are important partners for experienced traders wishing to open sizable positions.
Limiting Capital for Margins – Avoiding positions that require significant capital for margins will preserve overall trading capital and mitigate the impact of consecutive losses. By restricting margin capital to 1-2% of a position’s total value, forex traders can see through market fluctuations without significant stress and maintain consistency in their approach.
Using Stop-Loss and Trailing Orders – Stops can provide traders with a buffer against sudden market fluctuations, and they are an important part of sound risk management strategies. Again, this mitigates the risk of large losses and prevents emotional decision-making. In particular, trailing orders can protect potential profits by adapting to market movement and adjusting stop levels accordingly. Stops are vital when working with FX brokers with high leverage.
Mastering leverage in forex trades can take novice traders to the next level, allowing them to work with FX brokers with high leverage and make significant profits.
Understanding the fundamentals of leverage, calculating ratios, and keeping a maintenance margin will help traders make the best decisions with their existing and borrowed capital.
The importance of risk management when making leveraged trades cannot be overstated. While the potential returns are attractive to any trader, a disciplined approach, strategic use of stop-loss orders, and an awareness of your broker’s margin requirements are key to keeping losses at a minimum.
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