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Are you searching for the best Forex leverage for beginners’ guide? Keep reading… One of the most interesting aspects of trading in Forex and other financial instruments as contracts of differences (CDFs) is the aspect of leverage.
It comes as a surprise, for instance, to discover that it’s possible to use $100 to make a trade of $5,000 using a leverage ratio of 50:1. Thrilling as it may be, it’s vital to understand “how does Forex work and how does leverage trading work?” You must be mindful of the risk posed by using gearing/leverage.
Many novice traders simply ignore this vital concept and fail miserably by risking more than they are prepared to lose. The use of gearing has been described as a double-edged sword. It may either help or hurt you!
What is Leverage in Forex?
The Forex broker essentially provides two resources. They provide the trading platform used by customers to access the online decentralized Forex trading market. You also get access to leverage.
Prior to the Internet age, Forex trading was the purview of big financial institutions and central banks that would trade in huge quantities of currencies. It’s no wonder that a standard lot in Forex transactions is equal to 100,000 units of currency!
Retail brokers don’t have thousands of dollars to deposit and make transactions with. Many retail traders start accounts with a few hundred dollars. There is a problem when trading small units of currency. You may never make enough profits to justify the risk and time investment of participating in the Forex market.
Forex brokers solve this hurdle by loaning money to their customers. It allows them to multiply their trades and potential profits. So, to adequately answer the question of “what does leverage mean,” it is just borrowed money used to open positions.
Why Is Gearing Necessary?
The Forex market is highly liquid. Most of the trades involve major currency pairs like the EUR/USD. In reality, though, exchange rates of major currencies belonging to stable countries don’t deviate by huge margins.
For instance, on August, 31st, 2020, the EUR/USD opened at 1.1904 and closed at 1.1938. The change in the price is measured in the last decimal place. The smallest price movement is designated the name “Pip,” which also stands for percentage in point.
How to Calculate Pips to Find Profit and Loss:
We start by finding the price movement:
Close price – open price (1.1938 – 1.1904) = 0.0034. Exchange rates for most currency pairs are expressed in four decimal places, with the exception of pairs that include the Japanese Yen. So, mostly one pip is equal to 0.0001.
The number of pips for the price movement will be 0.0034/0.0001 = 34 pips.
Suppose you entered into a long position and purchased the currency pair when it opened at 1.1904 and sold it when it closed at 1.1938. You would have made a profit of 34 pips.
But how much would this be worth in terms of returns if you invested $1,000? It’s quite simple: just multiply the price movement by the value of the position.
Therefore, $1,000 X 0.0034 = $3.4 – that is the profit!
Now, if you used the leverage of, say, 100:1, you would have opened a position worth (100 x $1,000) = $100,000.
The resulting profit would be:
$100,000 x 0.0034 = $340
*Note that this calculation has not factored the spreads or commissions charged for entering into the trade.
*As a general rule for currency pairs that include the USD as the quote currency, the value of 1 pip in a standard lot of 100,000 units is = 100,000 x 0.0001 = $10. For a micro lot, the value of one pip would be 1,000 x 0.0001 = $0.1 or one cents. The value of a pip in a mini lot of 10,000 units would be $1.
How to calculate the value of a pip, different currency pairs? Luckily, there is a formula you can use:
Value of Pip = (One pip, its last decimal point ÷ Exchange rate) x Size of lot
For instance, if the current exchange rate of the USD/JPY is 108.18, the value of one pip in a standard lot size is equal to $0.09244. The calculation is done as follows:
Pip Value = (0.01 ÷ 108.18) x 100,000 = $0.09244
What would be the value of one pip in a standard lot for the EUR/USD pair with an exchange rate of 1.1904? Applying the formula, you get:
= (0.0001 ÷ 1.1904) x 100,000
= €8.400537 (value expressed in the base currency)
If the account is in USD, converting the EUR to USD using the exchange rate of 1.1904 would resort to:
= €8.400537 x 1.1904 = $10
If the account was in GBP, we would have to multiply the value of one pip into GBP. If the conversion rate for EUR/GBP is 0.88974, the pip value in terms of the currency used in the trading account becomes:
= €8.400537 x 0.8894 = £7.4710
What is Margin in Forex?
You need to deposit money in your trading account. It serves as the capital for opening positions. Most of the time, you only use a fraction of your account balance.
If you don’t use gearing, there is no margin. But if you use gearing, the margin is the amount you put out against the amount offered as leverage.
For instance, by using a leverage ratio of 100:1, you need to invest $100 as the margin to open a trade worth $10,000. The margin is held as a deposit. You get the margin back and additional profits for successful trades or lose a portion of the margin on unsuccessful trades.
So, how do we calculate the margin? You can certainly make the calculation easier using a Forex margin calculator. But it’s much more important to know how the calculation works by doing it by hand.
Assume that your account’s base currency is USD. You want to trade the EUR/USD pair by opening a position for a standard lot of 100,000 units. The volume of the lots is 1. Now, if the broker gives you Forex leverage of 30:1 and the current conversion rate of EUR/USD is 1.19047, what is the required margin to open the position of one standard lot?
Remember, we use the quote currency (US dollars) to purchase units of the base currency (Euros). How much margin does the broker need to allow us to open this position using a leverage of 30?
The formula used is as follows:
Margin Required = [Trade Size (Lot unit size x volume) ÷ leverage] x Exchange rate of the pair
Therefore:
The margin required in the example above
= [(100,000 units x 1 lot volume) ÷ 30] * 1.19047
Required margin in USD to purchase 100,0000 units of EUR with a margin of 30 is = $3,968.23
What if your account’s base currency is AUD? Well, now that you know the required margin in USD, you just convert USD to AUD using the current exchange rate as follows:
= $3968.23 x 1.3600 = A$5,396.7928
Leverage Calculator
You’ll be hard-pressed to encounter a Forex leverage calculator. Most of the calculators available on the web are margin calculators. It’s because the broker will state the gearing ratio. But assuming you wanted to find out the leverage the broker is offering, how would you go about it?
Well, most of the time, we calculate the margin-based leverage. For instance, if the lender offers a margin ratio of 30:1, the margin-based leverage would be determined as follows:
(1÷ 30) x 100 = 3.333%
If the leverage is 400:1, without using a leverage calculator, we know that the margin-based leverage is:
(1 ÷ 400) x 100 = 0.25%
It is expressed as a percentage and represents the margin requirement to the value of the overall transaction.
What does the Leverage of 1:1000 Mean?
The first thing to consider is that this Forex leverage is extremely high. In essence, it means that you may use $10, for instance, to open a position of $10,000. Very few brokers offer such high gearing. You should shy away from it because of the increased risk.
What is the Maximum Leverage Available?
The first factor influencing the leverage offered is the specific regulations in the country where the Forex broker is based. For instance, in 2018, a directive by the European Securities and Markets Authority capped the leverage brokers could offer at 30:1 for major currency pairs like the USD/CAD, etc.
For traders speculating on the value of cryptocurrencies, the leverage was capped at 2:1. Gold, major indexes, and non-major currency pairs can only be leveraged at 20:1. Additionally, EU-based brokers can only offer a 5:1 leverage to CFD stocks.
Brokers based in the USA are allowed to offer a leverage of up to 50:1 to retail traders trading major currency pairs. As you explore different brokers, you will find some offering leverage of up to 500:1. That’s because they operate from countries where leverages are not strictly controlled. It’s also up to the individual trading platform to offer the leverage they want.
So to recap, what is leverage in Forex? Well, it’s the additional amount of capital granted by the Forex broker that allows retail traders to open positions larger than the margin requirement and even account balances.
Leverage Trading Meaning in Profit and Loss
Note that it’s not a requirement to use the leverage provided by the broker. But when you use it, you’ll be engaged in leverage trading. It’s important to know how profits and losses work in leveraged trades:
Let’s look at an example:
Suppose you want to open a long position for the currency pair EUR/USD at 1.12181. You use a capital of $1,000 to open a standard lot using the leverage of 1:100. Now, if the price moves and you close the trade at 1.12381, you would have made a profit of:
1.12381 – 1.12181 = 0.0020 * 100,000 = $200
Alternative calculation:
The price moved by 0.0020/0.0001 = 20 pips. The value of a pip in a standard lot where the USD is the quote currency is $10, so 20 pips x $10 = $200
If the trade resulted in a loss of 20 pips, you would have made a loss of $200. Instead of using a leverage of 100, assume you used a leverage ratio of 10:1. You would have traded a mini lot of 10,000 units of currency with the value of 1 pip movement equal to $1. Therefore, a profit of 20 pips would yield $20, and a loss would be $20.
So, there’s a big difference between losing $200 and losing $20. While leverage can increase the profit you make, it certainly amplifies the losses, hence being called a double-edged sword.
You can also express the potential profits and losses as percentages of the trading capital used. The loss of $200, results in the loss of 20% of the margin applied to the trade, while $20 results in a loss of just 2%.
You Can Double or Lose More Than You Invested
Suppose, in the example above, the price moved by 200 pips against the position you took. It would result in a loss of $2,000. You would lose more than your invested capital.
In the past, brokers sought to recover debts after losing trades resulted in negative account balances. Nowadays, restrictions have been imposed in the form of negative balance protection.
Understanding Margin Calls
It’s also vital to understand the concept of margin calls in order to understand how leverage works in actual trading scenarios. The broker will want to ensure that your available balance at all times is sufficient to cover any resulting losses from open trades. To understand how margin calls work, let’s first define equity. It’s the overall value of your trading account, including your account balance.
You determine equity using the formula:
Total Equity = Unused Balance + Profits on any open positions or – Losses on any open positions
What if you don’t have any open positions? Then equity is the same as the unused balance. So, how do margin calls work?
The Forex broker will specify the minimum equity to margin percentage required to keep positions open (the margin includes all open positions). For instance, if it’s 50%, it means that available equity should not fall below 50% of the margined amount.
If the percentage falls below this point in case of sustained losses, open positions will be automatically closed by the broker until the acceptable level is restored.
Let’s apply this in an example:
You have an account balance of $2,500 and $1,000 is tied up as margin on an open position that has resulted in a loss of $2,000. The broker specifies that the equity should be less than 50% of the margin required to keep positions open.
You can find equity by the following calculation:
Equity = Unused balance + – profits or losses
Equity = $2,500 – $2,000 = $500
Expressed as a percentage of the margin we get:
= $500/$1,000 x 100 = 50%.
Sometimes, the required percentage before a margin call is 100%.
General Guidelines for Using Forex Leverage in Trading
Trading with leverage allows you to enter into larger trades. But we have also seen that it magnifies your losses. Play it safe by using the following guidelines:
- Only utilize leverage ideally after carrying out extensive Forex technical and fundamental analysis. Don’t enter into the trap of applying the maximum leverage to make quick profits. It’s a sure way to drain your account.
- Use stop-losses to reduce your risk when utilizing leverage.
- When trading on higher time frames, it’s recommended that you use lower leverage. If you’re trading on shorter time frames, it’s permissible to use more leverage to make sufficient profits from small price movements.
- Keep your risks low, for instance, by using the 1% rule. It involves not risking more than 1% of your account balance in any trade.
Conclusion
Leverage can greatly make your trading career worth it because it allows you to make large gains by risking a small portion of your capital. We have covered the fundamental question of “what does leverage mean in trading,” performed various calculations using Forex margin, and examined how risk is amplified when trading with leverage. You have also seen how to calculate the margin required without necessarily using a margin calculator Forex.
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