Leverage in Forex trading.
In forex trading, leverage means borrowing funds. In addition to trading financial assets such as equity and foreign exchange (“forex”).
Forex trading has grown rapidly thanks to the development of online forex trading platforms and the availability of cheap credit. The use of leverage in forex trading is often equated with a double-edged sword, because it increases profits and losses. In the case of forex trading, a high level of leverage is the norm.
An example of Forex Leverage
If you are an investor based in the United States and have an account with an online forex broker. Your broker gives you the maximum leverage allowed in the U.S. For example on a major currency pair of 1:50. This means that for every dollar you install, you can redeem $ 50 from a major currency.
You place $ 5,000 as a margin, which is a guarantee or equity in your trading account. This implies that you can 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 from your trading. (To keep it simple, we ignore commissions, interest and other fees in this example.)
Example 1: Buy USD / Sell Euros. Number of trades = 100,000 EUR
Assume you start trading when the exchange rate is 1 EUR = 1.3600 USD (EUR / USD = 1.36). This is because you expect the European currency to decline in the near future.
Your leverage in this trade is only above 1:27 (136,000 USD / 5,000 USD = 27.2, to be exact).
Because we use the euro in four digits after the decimal, each “pip” is equal to 1/100 of 1% or 0.01%. The value of each pip is expressed in USD, because this is the currency of the counter or quote currency.
In this case, based on the number of currencies traded at 100,000 EUR, each pip is worth 10 USD. (If the amount traded is 1 million EUR versus USD, each pip will be worth 100 USD).
When you test waters related to forex trading, you set a stop-loss of 50 pips on Buy position in USD / Sell EUR. This means that if the stop loss is triggered, your maximum loss is 500 USD.
Profit / Loss
Fortunately, you have luck as a beginner and the euro drops to level 1 EUR = 1.3400 USD in a few days after you start trading. You close the position for a profit of 200 pips (1.3600 – 1.3400), which means 2,000 USD (200 pips x 10 USD per pip).
Conventionally, you sell 100,000 EUR and receive 136,000 USD in your opening trade. When you close the trade, you buy back the euro that you have sold at a lower price of 1.3400, paying 134,000 USD for 100,000 EUR. The difference of 2,000 USD is your gross profit.
By using leverage, you can generate a 40% return on your initial investment of 5,000 USD. What if you only exchange 5,000 USD without using leverage? In this case, you will only sell euros equivalent to 5,000 USD or 3,676.47 EUR (5,000 USD / 1.3600). The amount of this transaction significantly means smaller than each pip which is only worth 0.36764 USD. Closing euro short positions at 1.3400 will result in a gross profit of 73.53 USD (200 pips x 0.36764 USD per pip). By using leverage, increase your profits exactly 27.2 times (2,000 USD / 73.53 USD), or the amount of leverage used in trading.
Example 2: Sell USD / Buy JPY. Number of trades = 200,000 USD
The 40% profit from your first forex trade has made you want to trade again. You turn your attention to the Japanese yen (JPY). Certainly traded at positions 85 to USD (USD / JPY = 85). You expect the yen to strengthen against the USD, so you start a USD sell position / buy JPY in the amount of 200,000 USD. The success of your first trade has made you willing to trade in larger quantities. That’s because you now have a margin of 7,000 USD in your account. Even though this is far greater than your first trade, you are comfortable with the fact that you are still trading for 350,000 USD.
Your leverage ratio for this trade is 28.57 (200,000 USD / 7,000 USD).
Yen quoted in two digits after decimal, so each pip in this trade is worth 1% of the base currency expressed in the quote currency, or 2,000 yen.
You set a stop loss on this trade at 87 JPY to USD, because the yen is quite stable and you don’t want your position to be stopped by random noise.
Remember, you buy JPY and sell USD, so ideally you want the yen to be appreciated versus USD, which means you can close your USD sell position with a smaller yen and pocket the difference. But if your stop loss is triggered, your loss will be large: 200 pips x 2,000 yen per pip = 400,000 JPY / 87 = 4,597.70 USD.
Profit / Loss
Unfortunately, reports of a new stimulus package formalized by the Japanese government have caused a rapid yen weakness, and your stop-loss is triggered the day after you trade buy JPY. Your loss in this case is 4,597.70 USD as explained previously.
In conventional terms, mathematics looks like this:
Sell USD 200,000 @ 1 USD = 85 jpy, ie + 17 million jpy
Triggering stop-loss results in positions of USD 200,000 sell covering @ 1 USD = 87 JPY , which is 17.4 million JPY The
difference of 400,000 JPY is your net loss, which at the rate of 87, yields 4,597.70 USD.
In this case, using leverage increases your losses, which amounts to around 65.7% of your total margin of 7,000 USD. What if you only sell 7,000 USD versus yen (@ 1 USD = 85 JPY) without using leverage? The smaller amount of this transaction means that each pip is only worth 70 JPY. A stop-loss triggered at 87 will result in a loss of 14,000 JPY (200 pips x 70 JPY per pip). Using leverage increases your losses exactly 28.57 times (400,000 JPY / 14,000 JPY), or the amount of leverage used in trading.
Tips When Using Leverage
When the prospect of making large profits without losing too much of your own money might be tempting, always remember that too much leverage can cause you to lose your shirt and more. Some of the precautions used by professional traders can help reduce the inherent risk of leveraged forex trading :
- Cover Your Losses: If you hope to take great profits someday, you must first learn how to keep your losses small. Cover your losses to manageable limits before they exit this limit and drastically erode your equity.
- Use Strategic Stop: Strategic stops are very important in the hours around the 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.
- Don’t Skip Your Head: Don’t try to get out of a losing position by doubling or decreasing the average. The biggest trading loss occurred because naughty traders were trapped in their weapons and continued to add to the losing position until it became very large, but had to be released because it was a disaster of defeat. The trader’s view may eventually be correct, but it is generally too late to make up for the situation. It is far better to reduce your losses and keep your account alive for trading on another day, rather than allowing it to expect miracles that will not reverse the huge losses.
- Use Leverage to Suit Your Level of Comfort: Using 1:50 leverage means a 2% step that is detrimental can erase all your equity or margin. If you are a relatively cautious investor or trader, use a lower level of leverage that you feel comfortable with, maybe 1: 5 or 1:10.
Although the high level of leverage inherent in forex trading increases profits and risks, using some of the precautions used by professional traders can help reduce this risk.